There’s growth, and then there’s sustainable growth
Apple’s share price is up close to 120% over the past 12 months. Amazon has gained almost 75%, and Microsoft has risen over 50%.
Even if the world wasn’t in the midst of a severe global recession, those would be extraordinary numbers for the three biggest listed companies in the US.
In an Asset TV panel discussion this week, three local boutique managers, all with hedge fund capabilities, attempted to make sense of this extreme market phenomenon.
‘It’s fair to say that there are a lot of really good quality growth companies globally, but it’s important for investors to keep in mind that when you are buying into an Apple or Microsoft or one of the big tech businesses, you have to understand what their underling sustainable growth rate is,’ said Iain Power, CIO at Truffle Asset Management. ‘Because, ultimately, that’s what your return looks like over time.’
In his view, price-to-earnings multiples cannot expand indefinitely.
‘Don’t forget about valuation,’ said Power. ‘Valuation is important.’
However, how does one determine what an appropriate valuation for these companies is? Given the extent of monetary interventions by central banks around the world, do asset managers need to think differently?
‘You have to be able to value a business,’ said Jacques Conradie, MD at Peregrine Capital (pictured). ‘But there has been a structural change in interest rates. This is the first time in human history that the entire developed world is yielding zero. This is a material change and there is just no way that it cannot impact the fair value of equities.’
If cash and bonds are guaranteed to deliver zero, or even negative, real returns, equity valuations have to shift higher because the discount rate has changed. Even with markets at record highs, that means that there is still potential upside.
‘We think that over the next three to six months the increased usage of some of these tech platforms does unwind at the margin,’ said Conradie. ‘But we also think that if you do proper DCFs [discounted cash flows] they still look very cheap if you select the right ones, like Facebook.’
Rob Oellermann, director and portfolio manager at Tantalum Capital, doesn’t find fault with this argument. But he does see other risks that investors shouldn’t ignore.
‘I completely agree that we are in a structurally lower interest rate environment and multiples could go higher,’ said Oellermann. ‘But there are other structural issues at play in these growth shares that concern me. It’s become a very crowded space. Just five shares in the S&P 500 currently make up 25% of the index. That’s as concentrated an index one has seen there in 30 years.’
This is apparent on the JSE as well.
‘Locally, just two stocks in Naspers and Prosus make up 22% in our All Share Index,’ said Oellermann. ‘That’s quite a lot of crowded behaviour. We like those shares – Naspers is our biggest equity exposure – and so we want to hold them. But we do think it makes sense to have a bit of protection there.’
Tantalum is currently employing a short fence strategy on its Naspers holding, which provides 15% downside protection, but which also limits the upside at the same level.
‘I do think that narrow market is generally a warning sign and is not an easily sustainable picture,’ said Oellermann (pictured below). ‘And I think regulators are also casting a beady eye in the direction of these big tech names. It’s a risk that needs to be priced somehow. I don’t think it’s the interest rate valuation I’m worried about. It’s more the fundamentals of the businesses and how one interprets those risks that worry me.’
The regulatory concerns are a significant issue for Power as well.
‘I think that all of these big tech businesses have reached escape velocity,’ said Power. ‘With the size of their ecosystems and the number of users they have, it’s very unlikely that a competitor is going to upset their current position in terms of dominance, or their current business models in terms of monetising their space.
‘But there is precedent that when businesses get really big and their benefit from a social and economic perspective is not spread to the wider community, you can potentially start to get risks building from the regulators. We’re not saying that Amazon will get broken up tomorrow, but to the extent that you get more and more market share gains and there is evidence of unsavoury businesses practices, then you get more regulation. And more regulation means more cost.’
This is ultimately a threat to their growth rates that is hard to quantify.
‘These are great businesses,’ said Power. ‘We don’t see that competitors are going to knock them down. But I would not be surprised, particularly if you see a change of leadership in the US, to see the spotlight begin to fall on these businesses, and that could bring a bit of reality back to those valuations.’
It is also worth considering that these businesses are already becoming targets politically as global tensions rise, particularly between China and the US. Asset managers can’t ignore that impacts that government actions might have in this space.
‘We have become used to an environment where geopolitical issues have not been that relevant,’ said Conradie. ‘But the world is going to be different over the next 20 years.
‘You need to build portfolios that can weather various shocks that you can’t model. That means diversification. We own US tech, but we also know Chinese tech and European tech, because you don’t know how this plays out. You have to diversify by company, currency, and business type to deal with this environment that you can’t predict.’