We have always invested on the basis that when the facts change we are prepared to change our minds. As of today nothing has changed. The global economy continues to slow and the world is struggling to adjust to an economic backdrop that is no longer turbo-charged by an abundance of cheap credit. Government spending policies, corporate business plans and consumer spending habits (that had become dependent on easy borrowing in recent decades) are being dismantled.
We think that the “New Normal” for the world economy will be that of a low growth, low return world. But we look upon this as an opportunity and not a threat for our investors. The West, in particular, is in the early stages of a prolonged period of structural reform. Small businesses that require large amounts of debt will find life extremely tough while those that can self-finance growth and have a successful international footprint are likely to do much better.
We believe the prevailing economic backdrop will allow strong companies to get stronger, but investors will have to be prepared to pay more for companies which can demonstrate genuine and sustainable growth. There has already been a noticeable shift in equity purchasing patterns over the past year and this has played into the hands of many of our underlying managers who have favoured robust stocks in more defensive sectors such as healthcare, consumer staples and telecoms.
Company valuation, which can be measured in different ways, is a subject that we get asked about quite often. So we include here some analysis, compiled by one of our managers Terry Smith. In this case, we are looking specifically at the price/earnings or PE ratio (i.e. share prices divided by earnings per share) as the valuation measure. The average price/earnings ratio for the S&P 500 Index since 1980 has been around 17x, i.e. share prices have been on average 17 times their earnings per share.
However, a selection of well-known consumer companies have produced such impressive compound returns since 1980, that one could have afforded to pay multiples as high as 41x for Colgate, 46x for Pepsi, 70x for McDonalds and 260x for Coke and still have kept up with the S&P 500 Index! There are plenty of other high quality international companies in our portfolios, which have PE ratios in the mid-teens, that we believe are ideally positioned to benefit from an emerging Asian consumer over the next thirty years. Although we will certainly experience periods of short term volatility, these should prove to be very profitable investments over time.
On the flip side, we are avoiding those managers who are biased towards cyclical sectors such as industrials and raw materials. This will continue for as long as China’s GDP contracts and the eurozone crisis persists. Sooner or later, the eurozone is going to have to decide between a more definitive fiscal union and the ending of the single currency. Either way, Germany as the leading creditor nation in the euro is going to have to pay, as 60% of its exports are to Europe. Our best bet is that eventually German policymakers will be forced to react to market pressures and that ultimately this will provide us with an opportunity to invest some cash into European equities at very attractive prices.
Finally a few words on corporate bonds, which have performed well in an environment in which the yield on the 10-year UK government bond (“gilt”) has fallen from 2 per cent to 1.5 per cent (as at 2 August 2012). In our opinion, a portfolio of carefully selected corporate bonds continues to offer an attractive yield premium over gilts and remains a strategically important asset class to diversify into for investors who do not wish to be wholly invested in equities.
John Chatfeild-Roberts is head of independent funds at Jupiter