Value investors shouldn’t get too excited about the recent uptick in inflation, as this will not be enough on its own to help them close the gap with their growth counterparts, according to Matthew Tillett, manager of the Brunner Investment Trust.
The UK consumer price index hit a 10-year-high of 4.2% in the year to October, while the US’s figure of 6.2% was its highest level in three decades.
Inflationary environments are generally considered more favourable for value stocks than their growth counterparts. In the latter group, the valuation is more dependent on the earnings they expect to receive in the future. The higher the level of inflation, the less future earnings are worth.
However, Tillett – who owns both growth and value stocks in Brunner – said the reality is “not so black and white”.
“Many companies find it difficult to operate in an inflationary environment because your input costs go up, and that’s not only going to eat into your margins, but also your capital base,” he said.
“Your capex will go up and return on equity will go down unless you're able to recover all of those with your pricing. And not all companies are able to do that.”
Contrary to conventional wisdom, Tillett (pictured) said that because many value sectors are capital intensive and have little pricing power, they are likely to struggle if inflation continues to rise.
He pointed out that in inflationary environments of the past, such as the 1970s, these were among the companies that did the worst, even if they looked optically cheap.
“So you've got to be careful,” he said.
The manager highlighted telecoms as an industry likely to struggle. Even though the amount of data consumed goes up every year, prices tend to go down or stay the same, due to low barriers to entry in this market – these companies are not just competing against their sector peers, but also broadband and cable providers that bundle multiple services together.
“At the same time, the capex requirements are quite elevated, because they have to invest in new equipment every time 4G or 5G comes along,” said Tillett.
“They always say that they’re going to recover it through more volumes and better pricing, but it just never seems to happen, because it's a competitive industry.”
As well as deep value stocks, the manager accepted that some growth stocks will be vulnerable in an inflationary environment. He said these will be the ones at the extreme end of the market, such as those that are highly valued even though they aren’t generating much in the way of profits.
However, he said that the middle of the market contains many businesses that should do well regardless of the macro backdrop, naming one growth and one value name from the same sector: digital payments.
First up is Visa, which was perceived as “one of the great growth stories” three years ago and traded at a large premium to the S&P, due to its dominant position in its market.
Yet it has de-rated significantly over the past three years, and Tillett said that although it is still on an earnings multiple in the low 20s, this valuation looks attractive compared with many of the out-and-out growth names in the US.
The manager said there are two reasons for this. “The first is simply because it has been impacted by Covid, as a chunk of its business is related to cross-border travel. Even though it’s not that big in overall revenue terms, it’s higher margin because there’s more stuff for the network to do, with anti-money laundering checks and other things, so it charges a higher fee,” he noted.
“Then the other factor comes back to what we’re seeing in the stock market itself where the frothier stuff has just detached.”
As an example of a value stock in this sector, Tillett highlighted Fleetcor, which operates a closed-network corporate payments system. Under this system, employees of a large company will receive a card to pay for all their expenses. Fleetcor processes all of these payments, reducing costs for the company and making fraud more difficult.
Although Tillett classes Fleetcor as a value stock, as it trades on about 14x to 15x earnings, he pointed out it has compounded earnings at about 20% per annum since listing in 2010.
“But it’s not exciting anymore,” he continued. “Like Visa, it has obviously been impacted by Covid because of the downturn in mobility, and that side will probably need a year or two to come back.
“But we’ve got a really compelling valuation here for a high-quality company with strong growth.
He added: “These individual examples don’t necessarily support those commonalities that you often see in the headlines.”
Data from FE Analytics shows Brunner has made 272.8% over the past 10 years, compared with 246.8% from the IT Global sector and 220.7% from its benchmark, split 70:30 between the FTSE World ex UK index and FTSE All Share.
Performance of trust vs sector and index over 10yrs
Source: FE Analytics
The trust has ongoing charges of 0.61% and is yielding 1.8%.
It is on a discount of 7.8%, compared with 12.2% and 10.5% from its one- and three-year averages.