What happens when traditional valuation rules no longer apply

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Clyde Rossouw, portfolio manager of the Investec Global Franchise Strategy, looks at the investment prospects for companies with valuable intangible assets, when traditional fundamental valuation rules seem to no longer apply.

Central bank market engineering has resulted in a landscape which is awash with artificial liquidity, creating a challenging environment for investors. Over the past few years equity returns have increasingly been driven by short-term expectations and sentiment rather than the long-term trajectory of the underlying business.

What’s behind investing in global franchises?

Our investment philosophy is to invest in businesses that we believe are of ‘high quality’. By this we mean businesses that should be able to generate superior returns on the capital that is invested in the business, and to maintain that competitive advantage for a long period of time. This typically comes from investing in companies that have valuable intangible assets, such as brands, patents, content or distribution networks that potentially allow them to make or generate great returns for the long-term, with low volatility of profits and consistent compounding of shareholder returns – or ‘bond-like’ equities.

Now that traditional fundamental valuation rules seem to no longer apply, what happens to the investment prospects for companies such as these?

While ‘quality’ companies with the characteristics outlined above tend to outperform through a full market cycle – those with valuable intangible assets like brands, patents, content or distribution networks – they have experienced a period of relative underperformance over the past twelve months. In our experience this type of underperformance typically occurs towards the end of a strong bull market in equities, when participants are drawn towards businesses with incrementally higher growth, but at the cost of greater economic sensitivity and less sustainability of earnings. Now that the US has ended its epic programme of quantitative easing, we remain cautious about those areas of the market that have already seen a very strong run and are avoiding stocks heavily exposed to economic momentum and market sentiment. At the same time, we are not necessarily convinced that the global economic situation is improving, with potentially worrying signs on the horizon in terms of future growth prospects.

A more challenging economic environment is likely to see a market drawdown, under which these quality companies should outperform because of the defensive nature of their earnings streams, their strong competitive advantages and pricing power.

Capturing market inefficiency

We identify companies with strong competitive advantages and high levels of pricing power which can result in superior returns on capital. The market’s implicit assumption around the fade rate of these high returns in certain instances means that a mispricing opportunity still exists relative to the broader market, and this is primarily the market inefficiency we seek to capture.

Even if the share prices of ‘quality’ companies weaken, their earnings and dividend performance will usually ensure that investors still receive a cash return during periods of market underperformance. We continue to believe the market underappreciates and undervalues Quality businesses, and this becomes even truer if economic circumstances deteriorate.

What are we avoiding in the portfolio?

We are avoiding most financials, mining companies and utilities given our reluctance to invest in some of the more capital-intensive parts of the market, and we have no interest in highly leveraged companies. We are positioned with material exposure to the consumer staples sector, while we are also seeing some attractive opportunities in information technology and healthcare.

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