Julian Fosh

UK Growth Fund at cheapest level relative to market for a decade

Julian Fosh

The UK Growth Fund is generally more expensive than the market on standard valuation metrics – reflective of the fact that the Economic Advantage investment process looks for high cash flow returns on capital, which often bring with them strong balance sheets and solvency, and these attributes attract a premium valuation. However, the portfolio’s premium valuation is currently close to the lowest levels seen at any point in the last decade.

UK Growth Fund is at cheap end of 10-year range

The gold bars on the chart show the valuation range of the portfolio over the last 10 years against six popular valuation metrics, where negative numbers (any value below the horizontal ‘zero’ line, which represents the market) denote a premium valuation – the portfolio is expensive relative to the market. As can be seen, on all measures except cash flow yield the portfolio is always expensive relative to the market – it has had a lower dividend yield, lower earnings yield (i.e. a higher price/earnings ratio), lower book-to-price (higher price-to-book), etc.

This is to be expected given that the characteristics we look for – intangible asset strength, high cash flow returns on capital (and the balance sheet strength and solvency that frequently accompany these) – will frequently command a valuation premium.

How do we square this with the obvious point that if one pays too high a premium for even the most fantastic business, the shares will underperform subsequently as all the good news is already priced-in?

Our investment process precludes us from investing in the most highly rated FTSE-350 stocks by requiring that, on initial investment, a stock must be rated more cheaply than the market on at least one of five metrics.

This is quite a high barrier but it provides an in-built discipline to only buy into new high quality stocks we like at times when they offer decent relative value compared to the market; this stops us from falling into the trap of overpaying. It should also help to ensure that the overall portfolio itself does not become too expensive, as new additions effectively rebalance towards the cheap end of the spectrum. We invest in quality at attractive prices, not at any price.

In recent months, we have been able to buy into both IMI and Bunzl on attractive valuations as the Covid-19 crisis led shares in both companies to de-rate relative to the market. In due course, we expect the Economic Advantage characteristics we have identified in these stocks to propel better-than-expected earnings growth and a rating expansion in the shares and hence share price outperformance. Bunzl in particular has already bounced back strongly as investor confidence recovered from its trough.

The good news for investors in the Fund is that it is currently at the cheaper end of its historical valuation range relative to the market. The green diamonds on the chart show where the current portfolio sits within its historic range. On five of the six metrics, the portfolio is at or near the top of its range (i.e. the cheapest level).

Our process is built around identifying companies whose earnings growth can prove more durable than the market expects due to their possession of intangible barriers to competition. The premium that such companies can command varies over the economic cycle according to (amongst other things) investors’ confidence about economic growth. At times such as the present, with severe economic dislocation and lack of earnings visibility, we would hope and expect that a portfolio such as ours would prove considerably more resilient than the market generally.

If you like what the UK Growth Fund does – applying the Economic Advantage process primarily to FTSE350 opportunities – then it seems that you can now invest in it at a highly attractive valuation point relative to its range over the last decade.

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Liontrust Insights

 

Key Risks

Past performance is not a guide to future performance. Do remember that the value of an investment and the income generated from them can fall as well as rise and is not guaranteed, therefore, you may not get back the amount originally invested and potentially risk total loss of capital. Some of the Funds managed by the Economic Advantage team invest primarily in smaller companies and companies traded on the Alternative Investment Market.  These stocks may be less liquid and the price swings greater than those in, for example, larger companies. The performance of the GF UK Growth Fund may differ from the performance of the UK Growth Fund and will be lower than its corresponding Master Fund due to additional fees and expenses.

Disclaimer

The information and opinions provided should not be construed as advice for investment in any product or security mentioned, an offer to buy or sell units/shares of Funds mentioned, or a solicitation to purchase securities in any company or investment product.  Always research your own investments and (if you are not a professional or a financial adviser) consult suitability with a regulated financial adviser before investing.

Thursday, October 1, 2020, 2:53 PM