Choosing between growth and value stocks is missing the point, the head of equity investment at Nomura Asset Management (NAM) has said.
Speaking to FTAdviser, Tom Wildgoose said: “Saying [the choice is between] growth or value is missing the point that there are undervalued high quality companies out there which will deliver an upside surprise eventually."
He said it was unclear to him why equities are commonly divided into either growth or value.
“People have historically said, well if you're not growth, you must be value. And if you're not value you must be growth. I think that very much oversimplifies the situation.
“Actually, good quality companies can either be high growth or low growth, it depends how you define quality.”
He said NAM’s definition of quality was a combination of strong competitive advantages, skilled management, delivering cash return to shareholders and high return on invested capital.
“The word growth doesn’t appear there,” he added.
“A component of the excess returns that a lot of 'quality' type funds have generated is actually just growth outperforming a lot because they define quality as free cash flow growth, and if growth underperforms, they’ll probably suffer.”
For years, the growth style of investing performed well in the world of low growth and low interest rates.
However, the bounce experienced by equity markets since the announcement of the first vaccine discovery in November 2020 has broadly boosted value equities at the expense of growth shares.
Changing valuations
In August, the co-manager of the £6.5bn Lindsell Train UK equity fund and the £2.1bn Finsbury Growth and Income trust said applying traditional valuation metrics to modern digital businesses was a “mistake” and outdated.
Nick Train wrote to clients and said that valuation multiples at tech firms today cannot be compared with those at older analogue businesses.
He wrote: “Investors, particularly US investors, understand the value that digital and data companies generate for their owners when they grow.
"Their capital-intensity is low, meaning returns on capital are high and copious cash generated. I say particularly US investors, because companies with similar characteristics have been right at the forefront of the bull market there and very high valuations have been achieved."
He said whether those high US valuations were justified was a moot point but added: "One thing is clear. Applying 20th century measures of what constitutes ‘value’ to digital companies is a mistake.
"Their returns on capital are simply so structurally higher than analogue/bricks-and-mortar businesses that [valuation multiples] we might have regarded as excessive 20 years ago can now justifiably be designated ‘cheap’.”
Quality investing
Wildgoose said he believes investors generally tend to underestimate the extent to which return on invested capital persists for good quality companies.
“It’s probably that intuitive idea that capital is attracted to high return on capital investment opportunities, which eventually competes away the high return on capital.
“And conceptually, logically, you think ‘fine’, but actually in many many cases there’s a barrier to entry which prevents capital being applied. I mean, the obvious one is in pharmaceuticals...look at the barriers to entry on not just regulation, but expertise.”
To try and prove this theory, the team worked on modelling expected return on capital.
“We took snapshots of the universe of companies at various points in history, and worked out the returns on capital at that point, quartiled them, and just observed what happened [to the return on capital over time].
“We took the median return on capital for each quartile through the period, and what you find is that very high returns of capital tend to decline, but they don't decline to cost of capital, they tend to decline to some industry average.”
sally.hickey@ft.com
