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Why growth isn’t as overvalued as you might think

26 September 2016

FE Alpha Manager Julian Fosh explains why he is not concerned by the high price-to-earnings ratios in quality defensive growth stocks.

By Jonathan Jones,

Reporter, FE Trustnet

Valuations of high-quality growth stocks are not as bloated as investors may think, according to Julian Fosh, manager of the Liontrust UK Growth fund.

Over recent months, many have grown concerned over the stretched valuations seen in the FTSE 100, with a number of the top growth companies at price-to-earnings (PE) ratios in the mid-twenties. Typically, companies are seen as ‘fair value’ if on mid-teen multiples.

Growth companies have outperformed for a number of years, with investors reeling from the financial crisis unwilling to invest in more cyclical value stocks.

As the graph below shows, over the last eight years growth has outperformed value by 20.37 percentage points, as investors have typically shunned risk.

Performance of indices over 8yrs

 

Source: FE Analytics

In the UK specifically, with government bonds bordering on negative yields and interest rates cut by the Bank of England to an historic low of 0.25 per cent, risk-averse investors have been forced into riskier asset classes such as equities – but have tended to head in areas of perceived safety.

So far in 2016 the FTSE 100 has risen 14.34 per cent, led higher by the ‘expensive defensives’, despite fears at the start of the year over a slowdown in China sending the market plummeting 12.93 per cent, and the shock Brexit vote send the index falling 12.55 per cent.


This has stretched valuations further and while some have been quick to point to this as a reason for value to come back into vogue sooner rather than later, FE Alpha Manager Fosh (pictured) sees growth continuing to outperform.

“Growth is always more expensive than value but the degree of expensiveness varies; the degree of undervaluation for value varies but growth styles are always more expensive,” he said.

“For us there’s no massive alarm bells going off saying all our stocks are overvalued on all measures – that’s just not the picture today at all.”

“So onto this question of how much more expensive is growth right now and how cheap is value and have they reached extreme levels – I think that depends on the metric that you use.”

He says that on a PE basis “growth is starting to look stretched” but adds that if you look at other metrics this is not so pronounced.

“Looking at our UK growth fund relative to how it’s looked in the last six years undoubtedly it looks expensive on PE but it doesn’t look so expensive, and is more mid-range, on dividend and free cashflow yield.”

He sees these metrics as just as important for investors looking to add growth stocks, as earnings can be notoriously difficult to predict.

“The problem with value investing is the most widely used method of valuation is the PE but what comes with the territory with value stocks is that you can’t really be sure about the E,” he said.

For example, he says the forecast for a housebuilder or a miner can be changed quickly by things like commodity prices and are based on current price levels, meaning they can fluctuate. In this instance, it is difficult for the market to assign a degree of probability on these earnings.

“Objectively value may look pretty cheap relative to growth but in two or three years’ time if those value earnings are not delivered then it will become apparent that it wasn’t as cheap as it looked. The point about quality stocks is the probability of the given earnings is much higher,” he said.

“Although some people using some measures are saying that growth as a whole is widely overvalued; the measures we use and looking at the stocks that we hold there are plenty of ours that are not overvalued at all.”

While not a top-down fund manager, Fosh says growth should outperform particularly at times of economic uncertainty, “which I think top-downers would say we’re going into now”.

As a result of this, he says that quality growth stocks are not as overvalued as they appear at first glance.

“Depending on where you start from value is not as overvalued as you might think it is particularly when you bear in mind that you can’t trust the quality of earnings from the likes the housebuilders as you can from the likes of Unilever and Diageo,” he said.

“So for us we’re finding when I look through UK growth there’s still plenty of companies that are cheap relative to the market on free cashflow yield on dividend yield. That comes down to the fact that we are in a difficult economic environment and obviously the picture is uncertain.”


Fosh’s £228m Liontrust UK Growth fund, run with fellow FE Alpha Manager Anthony Cross, has been a remarkably consistent performer over many years.

Indeed, it has been in the top quartile among its peers over one, three and 10 years and is in the second quartile over five years. 

Performance of fund vs sector and benchmark under Fosh and Cross

 

Source: FE Analytics

Since the managers took over the fund in 2009, it has returned 188.27 per cent to investors, outperforming the sector by 61.24 percentage points and the benchmark FTSE All Share by 65.09 percentage points.

The four crown-rated fund, which holds the likes of Shell, British American Tobacco and Reckitt Benckiser among its top 10 holdings, currently yields 2.02 per cent and has an ongoing charges figure of 0.9 per cent.

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Data provided by FE fundinfo. Care has been taken to ensure that the information is correct, but FE fundinfo neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.