Investors looking towards quality-growth stocks for protection against inflation should beware that they will not protect against this scenario if you overpay for them.
This is according to Abrie Pretorius, manager of the Ninety One Global Quality Equity Income fund.
Pretorius uses a quality-growth approach himself, meaning he prefers to hold capital-light businesses with intangible assets that allow them to deliver a high return on equity and return cash back to shareholders in the form of steadily rising dividends.
While these have done well in the decade or so to the start of 2022 as inflation has remained low, Pretorius said these stocks should also continue to outperform now this measure is on the rise.
“If you think about what you really want to own during periods of inflation, you obviously want companies that have pricing power,” he said.
“People typically say ‘capital-intensive business are best’, and yes, during the early periods of inflation they do well because they've got natural pricing power.”
However, the manager said that what value investors miss is, if inflation is persistent, as revenues and earnings go up, cashflows need to be reinvested in capex. This is where the argument falls down.
“If you build a mine or a factory, the depreciation cycle is about 10 to 15 years, so this is going to take some time to adjust,” he continued.
“If inflation is persistent, say 15% per annum for 15 years, a capital-light business will generate double the amount of free cashflow of a capital-intensive one.”
However, value investors are far from convinced by this argument in favour of quality growth.
Vitaliy Katsenelson, chief executive of the US-based firm Investment Management Associates, recently drew comparisons between the quality-growth stocks of today and the Nifty Fifty blue-chip group of businesses – including Coca-Cola, Disney, IBM, Philip Morris, McDonald’s and Procter & Gamble – at the start of the 1970s.
“Though today we look at some of them as has-beens, in the 1960s and 1970s the world was their oyster,” said Katsenelson. “These stocks were one-rule stocks – and the rule was: buy!
“They were great companies and how much you paid for them was irrelevant. [But] if you bought and held Coke or McDonalds in 1972, or any other Nifty Fifty stock, you experienced a painful decade of no returns. It took until the early 1980s until investors who bought Nifty Fifties at the top broke even. And this applies to almost all of them.”
For example, in 1973 McDonald’s had revenues of $583m and was on a price-to-earnings (P/E) ratio of 43. Yet Katsenelson said that if you bought in at that point you would have had to have waited until 1983 for the share price to break even, as although revenues had risen to $3bn, its P/E had fallen to 16.
For Coca-Cola, the wait was even longer – in 1972, it had revenues of $1.9bn and was on a P/E of 47. If you bought in then, you would have had to have waited until 1985 for the share price to break even, as although revenue had grown to $7.9bn, its P/E had fallen to 16.
Performance of stock
Source: Investment Management Associates
“What the Nifty Fifty showed us is that company greatness and past growth are not enough,” Katsenelson added. “Starting valuation – what you pay for the business – matters.”
While Pretorius is not a value manager, he agreed with Katsenelson’s point to some extent.
“The valuations were wrong,” he said. “That's where dividend growth is pretty interesting. Let's take the two extremes of the spectrum: first, classic value, which is really dependent on sustained high inflation because that's the only way these businesses are growing.”
Pretorius said that “time is the enemy for these companies”, because the longer it takes for the multiple to revert to the mean, the worse your return.
At the other end of the spectrum is classic growth.
“The risk here is that you fall in love with the company and you believe a dream they sell you that 20 to 30 years out and in periods of growth uncertainty, you get hope,” Pretorius continued.
“Now the beauty about dividend growth is there's quite a strong valuation discipline and so you need to be more sensitive in terms of that. Therefore, you can almost find the optimal combination between already strong businesses that can compound at attractive rates and decent valuations.”
He added: “So yes, valuation is a key tenant of this strategy and that's why a dividend yield at or above the market is quite important.”