Investors need to look beyond valuations when making decisions about companies that will survive and thrive or those that will struggle, according to Troy Asset Management’s Sebastian Lyon. 
The Troy Asset Management founder and lead manager of its flagship Trojan fund said too many analysts focus “myopically” on valuations, which can be “positively misleading”.
“Hard definitions of ‘value’ or ‘growth’ risk misrepresenting a more nuanced reality,” said Lyon (pictured).
Instead the firm aims to identify “excellent businesses at attractive prices”, which the fund manager said is more subjective than industry’s classification of value companies as those trading on low price-to-earnings (P/E) multiples.
“A very low valuation often betrays the dubious quality of a business or the weakness of its balance sheet,” Lyon explained. “This is particularly true during the later stages of a bull market.
“More often than not, rather than the bargains they appear, these are expensive mistakes waiting to happen.”
Indeed, the FE Alpha Manager said successful turnarounds are “few and far between in today’s market, where an increasing number of businesses are struggling to remain relevant”.
More recent examples of this can be found in the outsourcing and retail sectors, which have highlighted the challenge of corporate restructuring.
“Steady-state companies can look dull and do not offer the excitement of recovery,” noted Lyon. “However, with the exhilarating hope that accompanies turnaround situations, often comes gut-wrenching disappointment and, with it, permanent financial damage.”
As such, he said there were many companies the firm would not buy at any price regardless of how cheap they might appear.
“Avoiding the dross is more than half the battle when it comes to investment survival,” he explained.
The manager said companies with attractive returns on capital, financial strength and earnings growth are a more effective way of delivering steady returns.
While the past few years have been a ‘golden era’ for growth stocks fuelled by strong earnings growth, this has largely been concentrated in a handful of expensive stocks, according to the manager.
Performance of indices over 10yrs
Source: FE Analytics
As the above chart shows, the growth style – as represented by MSCI The World Growth index – has significantly outperformed its value counterpart over the past decade.
But chasing growth at any price, he said, can be just as damaging to a portfolio as investing in businesses with weak fundamentals.
“Extrapolating and overpaying for recent growth, even if this proves sustainable, is often the most expensive investment mistake of all,” Lyon warned.
When high valuations are excessive investing can turn into speculation and this is where the market finds itself currently, according to the manager, which should be a “warning signal” for investors.
Another feature of the market has been the grouping of disparate investment opportunities that can risk putting a barrier between investors and reality, according to the manager.
One example is the BRICs – Brazil, Russia, India and China – the group of fast-growing emerging markets that are often lumped together but which have seen correlations break down in recent years and move more independently.
The most recent example of this is the so-called FAANGs grouping – consisting of Facebook, Amazon.com, Apple, Netflix and Google-parent Alphabet – which Lyon described as “simplistic”.
While it has served to highlight the narrow leadership of the market, the manager noted that the usefulness of the grouping may have already peaked.
“Pigeon-holing markets or stocks in such a way is often unhelpful as the constituents inevitably follow different trajectories,” the Trojan fund manager said. “The operations of these businesses vary considerably, as do their levels of profitability.”
Performance of FAANGs over 5yrs
Source: Nasdaq
The FAANG stocks have ridden a wave of positive sentiment towards disruptive technology stocks that have changed many industries and seen incumbents struggle to adapt as new upstart companies take market share.
“Avoiding permanent capital loss from obsolescence requires engagement with the forces shaping the future, whether that be e-commerce, digital advertising, cloud computing or artificial intelligence,” he said.
“No sector is immune from the forces of disruption and we endeavour to select those companies that can adapt to succeed not only over the next two years but also over the next 10,” he said.
Additionally, Lyon said investors now need to consider what the material re-rating of equities in recent years will mean for returns going forward.
“Return expectations from current valuations should be low,” he explained. “Whilst there may be further frothy gains to be had in the short term, there is no failsafe indicator timing the exit accurately.”
The February sell-off, said Lyon, was a reminder that correlations in the stock market remain high and that diversification doesn’t offer the same protection as it has done in the past.
“With all asset prices inflated, there are fewer places to hide than in previous cycles,” said the FE Alpha Manager. “It has been so long since an economic downturn that the probability of a recession is being all but ignored.
“Good times do not last forever and the extrapolation of current earnings growth may be a mistake the market must re-learn.”
Over 10 years Troy’s flagship fund £4.2bn Trojan fund has delivered a total return of 92.6 per cent, behind the benchmark FTSE All Share’s gain of 108.48 per cent but ahead of the 85.42 per cent return for the average IA Flexible Investment fund.
However, over the same time it has been less volatile (6.89 per cent) than the FTSE All Share index (13.54 per cent) and investors would have lost less buying and selling at the worst possible times with a maximum drawdown figure of 9.21 per cent compared with 31.4 per cent for the benchmark.
“Conservative, active fund managers tend to outperform in falling markets,” Lyon noted. “Rather than panicking when markets turn down, we have the liquidity and the wherewithal to allocate to riskier assets at improving valuations.
“While the focus may be on relative performance today, savers will return to absolute values in the future. They always do.”
Performance of fund vs sector & benchmark over 10yrs
Source: FE Analytics
Trojan has an ongoing charges figure (OCF) of 1.02 per cent.