Traditional valuation metrics need reassessing when it comes to quality-growth stocks, where attractive entry points can still be found despite their strong run over the past decade, according to CQS portfolio manager Raphael Pitoun.
Pitoun was previously chief investment officer at Seilern Investment Management and manager of five FE Crown-rated Seilern Stryx World Growth and Seilern Stryx America funds, leaving last year to join new firm CQS.
During his time on the Seilern Stryx World Growth fund – which he managed between July 2014 and May 2018 – it made a total return of 101.79 per cent compared with a 65.68 per cent gain for the MSCI World benchmark and a 55.16 per cent return for its average IA Global peer.
Performance of fund vs sector and index under Pitoun
Source: FE Analytics
The manager, who has 20 years’ experience in the industry, will follow a similar process as at Seilern for his new fund – CQS New City Equity – by focusing on high quality growth stocks.
Pitoun takes an initial universe of around 3,000 developed market large- and mid-cap stocks, which is whittled down to a long list of 500 companies followed by a top 50. From the top 50, a high-conviction portfolio of 20-25 stocks is constructed.
Companies that are on the manager’s radar include those with the high-quality products and services, sustainable business models, a good history of innovation (particularly at a time of digital disruption) and excellent internal organisation.
One factor that each portfolio holding will have in common is strong relationships with clients, said Pitoun.
“I think the whole point of the fund is to focus on one particular aspect to understand the type of relationship between the company and the client,” he said. “We really want to make sure this relationship is healthy is transparent as adding value to the client and is sustainable.
“Most of the businesses we invest in are very strong brands but that is a consequence rather than the cause of the strengths of the business.”
Pitoun’s approach will also lead to some companies and sectors being excluded, with the process typically avoiding sectors such as banks, insurers, commodities producers, heavy industry companies, airlines and telecoms firms.
“We wanted really to focus on the quality companies looking at the figures, the financial statements, [and figuring out] to what extent they are going to grow but also looking to make sure that the businesses are healthy themselves,” said Pitoun.
Investing in quality stocks would have made some strong returns over the past decade as the low rates and pumping of liquidity into the market by central banks following the global financial crisis has helped drive investors into that part of the market.
As the below chart shows, the MSCI World Quality index has significantly outpaced its broader MSCI World sister index, making a total return of 335.3 per cent – in sterling terms – compared with a 248.68 per cent gain for the latter.
Performance of indices over 10yrs
Source: FE Analytics
Given such growth, there have been some questions over whether all the easy gains have already been made, particularly as some of the drivers behind performance – particularly the post-crisis stimulus measures – have begun to unwind.
Yet, Pitoun said there is further room for further upside in the quality names it invests in.
“In the companies that we’re looking at we are comfortable with the level of valuations,” he explained.
“We see a lot of investment opportunities because many companies are in the middle of a very large investment cycle. They are building their networks – affecting their capacity – and so it might inflate the P/E [price-to-earnings multiple] or it might affect the free cashflow yield. But that’s not something we are overly concerned about.
“If we think that those investments are going to be relevant to drive growth over the very long term we really must welcome then.”
The global equity manager said he looks at different metrics to determine true valuations and is “completely agnostic” to P/E and other multiples.
A case in point is the recent highs reached by the blue-chip S&P 500 index, according to Pitoun, which has continued to rise despite a loss-making 2018, its first annual loss since 2008.
Over the past 10 years, the S&P 500 has made an impressive total return of 298.68 per cent, in US dollar terms. In comparison, the FTSE 100 is up by just 173.05 per cent, in sterling terms.
Performance of indices over 10yrs
Source: FE Analytics
The manager said that capital markets this year were reacting to an “extraordinary” 2018, which has placed a question mark over traditional valuation metrics.
The reason is that the risk-free rate – the rate that an investor can expect to earn on investment carrying zero risk – as indicated by the yield on a 10-year US Treasury was capped at 3.2 per cent, as unemployment in the US and president Donal Trump’s tax cuts took effect.
“This requires a complete change in terms of algorithms in order for investors to reach their return objectives,” he explained. “The first consequence of that is the democratisation of elevated P/E.”
Pitoun continued: “In a world where at the peak of the cycle the risk-free yield is 3.2 per cent, investors will be increasingly open to high multiples.
“Also, what the bond market has been expressing last year is the confirmation that the world economy has entered a period of slower structural growth.
“It is therefore consistent that companies providing growth are rewarded by investors.”
Yet, there are also risks to this outlook, warned the CQS New City Equity manager, particularly with a more challenged environment for growth.
The International Monetary Fund recently revised down its forecasts for 2019 growth, falling from 3.5 per cent in January to 3.3 per cent in April’s World Economic Outlook.
The manager said there are two key risks. Firstly, as economic growth becomes more difficult to find governments will “increasingly fight for it” – as evidenced by Trump’s trade renegotiations – raising the risk of economic disruption.
Secondly, growth – particularly in the US – has been driven by the accumulation of debt which has put pressure on credit quality and made ratings more sensitive to any changes in interest rates.
“The results from US banks show some early signs of deterioration in non-consumer [loans],” he concluded.