Investors have spent much of the last two years seeking apparent certainty by buying growth stocks that have already delivered, and ignoring prices for those that are deemed less certain.
Nowhere has this been – at least until very recently – more apparent than in the share prices of growth stocks such as the FAANGs –Facebook, Amazon, Apple, Netflix and Alphabet (Google). These stocks have rocketed over the past two years as investors have chased growth at any price.
The volatility of recent weeks notwithstanding, the FAANGs remain the standout performers in the US, but with such a narrow focus for investors, cheaper companies with good long-term growth prospects are being overlooked.
As such, this feels like the most productive hunting ground to find cheap firms since the European sovereign debt crisis, as while Mr Market is focused on paying higher and higher prices for the already fully delivering expensive growth stocks, there are opportunities in abundance to pay lower prices for everything else that has been left behind.
Signs that things are changing are becoming more apparent, albeit slowly. Safety first stocks such as utilities companies are starting to come under pressure as interest rates – and bond yields – continue to climb.
Economies around the world are growing at a high rate, and many of our value stocks are either growing robustly or have significant latent growth potential, but for some reason, they just get cheaper.
Using our philosophy known as PVT – potential, valuation and timing – we are attempting to exploit this by buying firms with the potential to grow their profits at both the right time in the cycle and at a good price.
A recent example of this is the increase of our Global Recovery fund’s stake in UK firm Chemring, which I would describe as a “classic recovery firm” with the potential for higher return on capital in the medium term.
We also bought into insurer Prudential, Brazilian transport firm EcoRodovias and the largest global geoscience company, CGG. Outsourcers such as Capita also represent a good opportunity for growth, despite investors shying away from them in the wake of Carillion’s collapse.
Outsourcing companies are indeed what we would term classic recovery stocks in the current environment. Capita, for example, has many of the hallmarks that we look for in a recovery thesis: forecast operating margins of 8 to 9 per cent are well below the long-term average of 13 per cent and the catalyst of a new management team, with a fresh set of eyes, are addressing this with an initial cost reduction target of £175m by 2020 that would bring it more in line with industry cost ratios.
Focusing on such companies is an approach that will struggle when hot money flows into popular investments with little or no consideration for the price paid.
Indeed, amid a move to focus on “disruptors” across most industries globally, there have been an increasing amount of “value traps” to catch out unwary investors.
But that said, there is still no excuse for paying ever higher valuations for technology growth stocks, nor a reason why a mining company like Anglo American trades on such a low cash flow multiple. It means there really are an abundance of options out there for recovery investors.
Hugh Sergeant is chief investment officer of equities at River and Mercantile Asset Management