Those familiar with our investment style may be surprised that we are previewing the European Central Bank’s policy decision on 10 March. 
Our process is based on in-depth quantitative screens combined with qualitative analysis of companies’ published report and accounts. We explicitly focus on fundamental developments at the corporate level, without seeking to predict the actions of politicians or central bankers.
There is, however, no doubt that we – along with other market participants – are subject to the actions of these policymakers due to the substantial impact they have on both investors and company managers.
Over the last five years, an extremely strong precedent has been set for the actions of the ECB and other central banks to determine the investment style bias of the market. Near-zero interest rates along with massive money printing programmes effectively bailed out the most troubled companies in the wake of the global financial crisis. Investors responded by seeking risk, bidding up the prices of cheap assets with ‘contrarian value’ appeal.
Performance of index over 5yrs
Source: FE Analytics
The most rewarding investment strategy under these conditions was often to focus on stocks on inexpensive valuations as measured by metrics such as market capitalisation relative to sales or accounting net asset value, as they performed well in an environment of rising optimism and enthusiasm for risky assets.
Some labelled this process as a ‘dash for trash’. In our quant screens, this effect showed itself through a compression of the market’s valuation dispersion; simply put, share price gains were indiscriminate, resulting in the variation in share price valuations being far less than the variation in the quality of the underlying businesses.
Shares in distressed companies were bid up to artificially high multiples, while solid growing companies were not afforded the premium valuation they deserved.
For growth investors, periods of compression such as this are unhelpful – and all the more frustrating due to the artificial method by which it was brought about. We focus on company cash flows as we believe this to be the primary long-term determinant of shareholder returns. Cash flow is effectively a proxy for fundamental quality, but it was significantly out of fashion as investors instead focused on monetary policy.
Returning to the present, Mario Draghi recently stated that the ECB’s impending March 2016 meeting will see it “review and possibly reconsider” its policy stance with “no limits” to the tools it may adopt.
This has raised the prospect of policy once again driving markets. But to understand what the 2016 ramifications may be, it is first necessary to look at how the ECB’s actions affected markets throughout 2015.
The nature of our cash flow-based process is that it tends to lead us to have a portfolio bias to ‘quality’ growth companies, but we can accentuate or dilute this tilt depending on our view of market conditions.
At the start of 2015 we had identified the market’s narrow valuation dispersion as indicative of a ‘growth-oriented regime’ – one in which strong companies with good cash flow growth should outperform as valuation dispersion widened from extremely low levels.
However, the ECB announced a larger-than-expected quantitative easing programme in January 2015, which reinvigorated ‘risk on’ sentiment and triggered an explosive first quarter rally. Valuation spreads, already remarkably compressed, tightened further. Contrarian value stocks led the rally.
Performance of indices since January 2015
Source: FE Analytics
But now, one year on from that boost from Draghi, this style bias has reversed significantly with growth & quality strategies having outperformed contrarian value.
So what has changed?
The feel-good effect from the January 2015 announcement was sharp but its duration was actually quite short, barely lasting until the programme’s actual implementation in March.
As concerns of a global nature – Chinese and emerging market slowdown, and the related commodities rout – began to weigh on markets as 2015 progressed, some commentators suggested the ECB’s monetary weapon had proved to be more of a peashooter.
Slightly perversely, the underwhelming nature of the ECB’s programme proved a boon for growth investors.Although it [so far has] proved ineffective in stimulating growth in economic activity and price levels, this has forced investors to focus more on the underlying prospects – or fundamentals – of businesses.
As a gloomier global macroeconomic picture took hold, the dominant investment regime through the remainder of 2015 became one of low but widening valuation dispersion in Europe.
As a result, good quality growth companies began to once again command a valuation premium. When valuation spreads widen, it is typically representative of what we call a ‘show me’ phase in which investors begin to discriminate more between stocks – they want to see firm financial evidence of recovery in companies’ financial results. This suited our investment style.
Subsequent ECB attempts to stir animal spirits failed; value investors latched on to comments from Draghi that the ECB stood ready to adjust the “size, duration and composition” of QE, but the policy measures subsequently announced in December 2015 disappointed relative to their expectations. This helped the growth regime persist into 2016, with these stocks outperforming during the market’s inauspicious start to the year.
Performance of indices in 2016
Source: FE Analytics
It is important that we do not get carried away by this favourable style shift. We’ve been in this position before, back in late 2014, when there appeared to be a nascent increase in valuation dispersion in European markets, but this was reversed by the ECB’s announcement in the first quarter of 2015.
As we edge towards the March 2016 decision, expectations of policy changes have begun to mount. Will the ECB repeat its January 2015 surprise, or will it disappoint against the very expectations which it has fostered, in an echo of December 2015’s events?
This potential crossroads is particularly relevant to growth investors with the investment style having performed very well in Europe markets over the last year.
We should be prepared for the possibility that aggressive ECB action could once again spark an explosive period of equity market gains, led by contrarian value.
But the lessons from last year suggest that such an outcome should not be a trigger for long-term investors to rotate out of growth strategies. In fact, moving wholesale into contrarian stocks in order to benefit from any ECB-led rally could prove very hazardous if either the March statement underwhelms, or sparks a rally which is as short-lived as last year’s.
While there may be value opportunities in select sectors where share price valuation dispersion has increased substantially, such as oil & gas, overall we think that the market needs to adjust further so that dispersion once again reflects the variance in company prospect. This process should continue to favour quality growth stocks.
Samantha Gleave is co-manager of the Liontrust Global Income and Liontrust European Growth funds. All the views expressed above are her own and shouldn’t be taken as investment advice.
