Investing in Quality Growth Businesses

For dedicated Quality Growth investors, the last couple of years have presented an unusual set of challenges. The primary one of these has been the explosion in long bond yields triggered by war in Europe and generated by a sharp if temporary rise in inflationary pressures, although many of these pressures have clearly abated. Nonetheless, many observers, commentators, investors and, above all, the press, remain intent on seeking to negate the evolution of the natural pressures of deflation that have, if anything, been accentuated in certain leading world economies, notably China.

One result has been that the valuation of Quality Growth businesses has remained hostage to the yields on longer-maturity government bonds. Although seasoned investors will agree that bond markets dictate share price movements in the short term, this fact has been highlighted by the explosion in volume of national debt/government bonds over the past more than forty years.

This valuation pressure on the share prices of Quality Growth businesses stands in direct contrast to the generally observable lack of net debt on the balance sheet of such companies. And although share price pressures of debt-free or debt-light Quality Growth businesses present a buying opportunity to long-term thinking investors (as is currently the case), such an opportunity usually takes some years for investors to feel vindicated.

Still, history will repeat itself as it always does…

This inevitably calls to mind the adage that “earnings drive share prices”. The past two years have presented some evidence for those investors who disagree with this adage to feel that the idea of earnings driving share prices is no more than a slogan. Although earnings of many Quality Growth businesses have been robust, as is usually the case, share prices have been ignoring this robustness as their influence is not from earnings but from long bond yields.

Indeed, it has been difficult to argue against this pushback, especially when short-term growth interruptions or rare profit warnings have been brutally reflected in sudden, and sometimes substantial, share price declines.

For investors in Quality Growth businesses, another “roadblock” has been starkly felt by the advent of artificial intelligence and those companies who stand at its forefront or thereabouts. Few investment managers, with the exception of true Quality Growth investors, have avoided the temptation of going with the flow, of jumping on the momentum bandwagon of chip manufacturers or cyclical businesses. Familiarity with their share prices exceeds, by far, the required profound knowledge of their underlying businesses and, crucially, the transparency of their future earnings. Yet such enhanced knowledge is key to the better assessment of risk.

For short-term investors, this is a panacea. But for long-term investors in Quality Growth businesses guided by the established principle of durable earnings driving share prices in the long run, the challenge is evident. But of greater importance is the risk of damaging a portfolio’s structural soundness and risk-mitigation by throwing the towel and jumping on a bandwagon with small wheels.

There is a further challenge to the Quality Growth investor. As established equity indices have long been the holy grail for investors and advisors, they are considered as the benchmark against which all investment returns should naturally be measured. On this, there is general agreement across all styles of investing. This benchmark, however, is viewed as a return benchmark, not one relating to risk. It bears little or no resemblance to a benchmark or universe of Quality Growth businesses, such as we have been monitoring at Seilern for decades.

The true Quality Growth investor is guided by this universe of Quality Growth businesses rather than by a benchmark of hodge podge companies with varying degrees of investment risk, and whose long-term earning power is not measurable, indeed often non-existent. By contrast, the ten golden rules of Quality Growth investing will govern the approach adopted towards risk by their investors. Such risks have frequently been discussed in these columns and do not change over time. Many “factors” are created by short term investment trends, themes, or even fads, ones largely by-passing the essential risk mitigation required by all serious investors. The ten golden rules of Quality Growth investing will serve to underpin risk-adjusted returns over the long term. The performance of a true Quality Growth investment portfolio should thus be measured against its universe of peer group businesses rather than against a set of incomparable other companies which happen to be quoted on a stock exchange. This peer group will include companies currently not in a portfolio, not for reasons of risk but, instead, to comply with portfolio construction rules.

This is the real benchmark a portfolio of Quality Growth businesses should be compared to.

To many investors, long term returns are the product of a series of short-term investment results. But this observation, whether true or false, does not conform with Quality Growth companies and their underlying business risks.

For a better understanding of this principle, it is worth remembering how the overriding value attraction of a Quality Growth business is of a terminal nature. What does this mean and how is this terminal value calculated?

Contrary to average businesses whose fortunes are largely controlled by events or economic cycles, the fulfilment of the ten golden rules of Quality Growth are key to their long-term survival and above-average growth. Whereas average businesses allow the growth in their earnings and revenues to be calculated with some accuracy over a span of no more than two or three years into the future, Quality Growth businesses are different. Owing to the dependency and forecastability of their earnings stream and the lack of net debt on their balance sheets, it is possible for their profits to be estimated with a certain degree of accuracy over a much longer period of time, up to ten years into the future. At Seilern, this constitutes the core of the research and analytical work and has been so since inception.

Analysts of average cyclical businesses will base their assessment of whether a stock is “cheap” or “expensive” on the product of two- or three-years’ worth of earnings forecasts, as mentioned. Today’s share price will be divided by estimated earnings one, two or three years hence and a judgment will be made as to the attraction of the stock in question. Further analytical work will neither be possible nor required for reaching an investment conclusion. This conclusion will likely be subject to alteration, also influenced by the short term.

The approach to assessing the valuation attraction, or lack of it, for Quality Growth companies is thus different. Long-term earnings far into the future will be discounted back to the present (by way of a sensible discount rate). When comparing the product of this exercise with the current share price, it will become noteworthy how the lion’s share of a business’s value is thus derived from the reliable expectation of distant earnings.

Clearly, a number of factors can derail this growing stream of earnings whose certitude, as mentioned, is based on the ten golden rules of Quality Growth investing. And some of these factors became visible in the past couple of years of political and economic uncertainty. Even deep research into their businesses cannot entirely shield investors from outside influences beyond their control, such as geopolitics or regulation, or both. A clear example of this lies in the attempted dismantling of the world’s economic order or through antiquated methods of mercantilism, as practiced by the unpredictable tenant sitting in the White House. What has struck the Quality Growth investor nonetheless is the enduring earning power of many such businesses despite headwinds beyond their control in the past few years.

This indicates that the share prices of most of these businesses have not been influenced by their earnings but, instead, by the notional discount rate offered up by the long bond yields in fixed income markets. Only earnings disappointments have undergone severe punishment (much more severe than in past years of low or negative interest rates). Positive earnings surprises, instead, have caused a shrugging of the market shoulders…

When it comes to the short-term market valuation of Quality Growth businesses, the fundamental question for investors is the direction of long-term bond yields around the world. Will Trump’s aggression cause inflation to return, as expected by most observers? Or will the natural forces of disinflation which have largely prevailed in the world economy prove to be immutable and, further, compounded by the advent of artificial intelligence and future unknown forces? In other words, was the recent inflation scare no more than that or is it here to stay? And, if so, will the bond yields stay higher for longer?

A discussion of what drives the prices of bonds, of equal or greater importance than the equivalent discussion within stock markets, will be left for another day. Suffice it to say that while bond prices may drive share price valuations in the short or medium term, catching most businesses – especially long-duration businesses – in its net, it is the earnings and their visibility that reign supreme for the long term.

As a result, many Quality Growth businesses are now trading at levels whose attraction for the long term is evident, if mostly only to investors with patience and an unlimited time horizon. Such investors are, however, the exception and not the rule. And the expected investment returns inherent in today’s share prices of such Quality Growth businesses will be enjoyed, once again, only by a minority of investors. The choice is theirs to turn down.