The majority of investors think about valuations in an unhelpful way, according to Scottish Mortgage’s Tom Slater and Lawrence Burns.
The trust is renowned for its investments in ‘future winners’, or growth-focused businesses with the potential to disrupt their industries and the way we live.
These companies, however, which are often in the technology space, have been trading at hefty premiums due to their success over the past decade, coinciding with a favourable low-interest-rates environment.
Now that money is more expensive, investors have started to worry about valuations and to wonder whether splurging on expensive and possibly overhyped stocks is the right strategy.
Historically, however, the stocks that have driven the Scottish Mortgage portfolio upwards had been bought at premiums, co-manager Lawrence Burns explained.
“If you go back over the things that have driven Scottish Mortgage’s performance over the long term, you'll find that when we first bought them, they will all have been at a high multiple and have actually added the most value over time,” he said.
“What you are looking for is a company that has a very large growth opportunity and has potential to grow earnings. If you can get it for less, that's great, but the stock often comes at a price. But if it can grow exponentially, you can quickly wear down that multiple with the earnings.”
This, however, doesn’t mean that valuations are completely unimportant. Admittedly, “you can’t be an investor and not care about valuations” according to Burns, but there are ways to do this that are more effective than others.
Slater added: “So many people focus on the ratio between the price of a company and its earnings and they look at the earnings for this year.”
Companies will therefore be valued 20, 30 or 40 times this year’s earnings – which doesn’t make sense to him.
“We don't think you can look at those numbers and say anything useful about what the share price is going to do in the next five years. If one stock starts on 20 times earnings and another stock’s on 40 times earnings, there's no evidence that the one that’s on 20 times earnings is going to do better than the one that’s on 40 times earnings. And that’s where we focus our efforts, not on whether it's on 20 times or 40 times to start,” Slater noted.
This is why it’s important to think about time horizons, added Burns.
“A spot multiple doesn’t tell you if a company is expensive or cheap on its own. The way we go about it is we think firstly over our time horizon, so asking ourselves: What happens to these companies over five and 10 years? That’s the way we think about value,” he said.
“Your starting point today is a certain valuation. But what do we think the revenues, the profits and the market will pay for that in five or ten years’ time? That’s what guides us.”
But the managers don’t stop there, they also play out different scenarios.
“There are multiple future scenarios. So we'll build out what would be called a base case, which we think might be the most likely, then a bull case, which would be optimistic, a blue-sky case, which would be very optimistic but unlikely, and also the negative scenarios,” Burns said.
“We consider the entire spectrum of those possibilities on a five-to-ten-year time horizon. Valuation is the starting point which you're investing in. It really doesn’t matter, but it has to be seen through a time horizon and through a probabilistic nature."