The Aubrey European Conviction Strategy has had yet another good year returning 25.2% year-to-date to the end of November versus 18.1% for the MSCI Europe index. Over the past 5 years the strategy has returned 141.7% vs 49.8% and over 10 years 337.5% vs 135.2%. This has been an abnormally long cycle on any historic measure. Can it continue for yet another year? As much as we have confidence in the companies in our portfolios and applaud their efforts and financial results, we are not oblivious to market concerns.
VALUATION
We looked retrospectively at 2019 pre-pandemic valuation levels and discovered that the PE on the fund was actually higher than where it is today.
The main difference is that in 2019, the average earnings growth in the portfolio was 20%, whereas the average earnings growth in 2021, on the basis of nine-month earnings, has been 115%, with just over 70% of the portfolio companies having reported. This suggests a retrospective PEG of 0.4x in 2021 compared to 1.9x in 2019. In 2020, the pandemic year, EPS growth fell to around 15% and the year-end PE rose as high as 66x. This was of course an abnormality with the market anticipating recovery in 2021, which clearly we have seen. You might say that it is forward looking PEGs that matter, and indeed, this is where we focus our analysis.
In FY 2022 we are expecting growth in the region of 36%, which leaves the PEG at 0.8x, attractive on any historic comparison.
The portfolio focusses on high growth areas and the PE reflects that, being twice the 14.6x PE of the MSCI Europe index, which represents the average for Europe’s quoted companies. The average historic PE on the MSCI Europe index (since 1998) has been 23.4x, and the forward PE 13.8x (since 2005) so it is actually not so much higher than average currently. Compared to MSCI USA index at 21.3x, the European forward PE looks inexpensive. The portfolio’s expected forward EPS growth rate at 36% is 3x higher than the European index at 10.6% and 7.5x higher than the MSCI USA index at 4.8%.
INTEREST RATES
Looking back on periods where a 15x PE was considered normal and one much in excess of 20x as expensive, interest rates were substantially higher. Could we return to a similar environment? It is worth reminding oneself that in the decade before the Global Financial Crisis the UK base rate was typically around 5% and in the 1980s it gyrated wildly from around 8% to as high as 17% at moments of stress. At 15x the earnings yield would have been 6.7%, and if the interest rate was 5%-8%, 15x would have been understandable, and offered little by way of equity risk premium. So the question is really, what will happen to interest rates in 2022 and beyond, and will we have to discount future cashflows at a much higher risk free rate?
We believe that with substantial growth still expected from the fund’s companies in 2022, the value of the portfolio is more than capable of holding up reasonably well with slightly higher interest rates. If we get a protracted period of high interest rates, the compounding effect will be larger, and it would be reasonable to expect PE contraction. However, thus far it looks as if central banks are set on keeping interest rates artificially low.
DEBT
Even if one questions the central bank narrative that the current spikes in inflation are short term in nature, the members of the UK monetary policy committee will be keenly aware that even minor increases in rates will make government debt service costs prohibitive, let alone the 400-700 basis point increases of previous cycles. How long their stance can persist is anyone’s guess. Logic suggests interest rates should be somewhere near the current rates of inflation which have risen above 6% in the US and to over 4% in Europe. In the end it may depend on whether buyers of government bonds will continue to play the game. It could be they are starting to comprehend the fact that the world is in a debt trap, as suggested in a recent FT article by Ruchir Sharma of Morgan Stanley, and that higher rates are unsustainable without triggering an economic collapse.
Sharma notes that total debt has tripled over the past 4 decades to 350% of global GDP. As central banks dropped interest rates and printed money this has flowed into stocks, bonds and increased the scale of global markets from the same size as global GDP to four times the size! The number of countries in which total debt amounts to more than 300% of GDP has risen over the past two decades from half a dozen to two dozen, including the USA.
FUND STRATEGY
As portfolio managers we endeavour to buy strongly cash generative companies with low debt or net cash positions. Average net debt to equity in the portfolio is 10%, with half our portfolio companies sitting on net cash, and fewer than a handful having any noticeable debt at all, and those are mostly financing acquisitions or capacity rollouts. We focus on companies with high gross margins and an ability to pass through inflationary pressures, whether these stem from higher energy, raw materials or logistics/supply chain issues. Avoiding commoditisation has been crucial to the fund’s outperformance in recent years and we will continue to adhere to this practice.
The portfolio is comprised of many companies with long term structural growth tailwinds. It plays into behavioural change, whether at the business or consumer level, and accesses long term growth trends. We are going through a period of transition, digitalisation and decarbonisation are two of the most obvious examples, and companies that are facilitating this are finding extraordinary levels of demand for their products and services. We believe this demand will hold up regardless of the interest rate environment.
When printing money seems to be the default solution to the debt problem, anyone holding currencies or bonds is going to see real values eroded. At any given moment equities are only worth what anyone is prepared to pay for them. But over the long-term, European equities have delivered 5% average annual real rates of return (i.e. over the rate of inflation). We structure our portfolios to deliver well in excess of that by only investing in companies capable of generating cashflow returns (CROA) of 15% or more on their assets. Our contention is that over the long term the stockmarket return of a company should approximate its CROA. It is unlikely to exceed it. The current CROA in the portfolio is 32%. This is a nominal return, but its high level suggests that even with higher inflation, the portfolio should be capable of delivering a double-digit real rate of return, and comfortably outperform the average return of the benchmark index long term.
Markets are awash with liquidity and this needs to find a home somewhere, so asset price inflation is inevitable, and money is likely to seek out higher returning assets. Liquidity in the system is also supporting relatively high levels of corporate sales and earnings growth, which in turn is supporting valuations. That does not mean to say that this will persist indefinitely, and we are very conscious of the need to monitor holdings to ensure PEs and PEGs remain defensible.
From the foregoing, it is hopefully clear that our concerns going into 2022 are more of a systemic nature, rather than being portfolio specific. We are concerned by the sabre rattling on the Ukrainian border and China’s intentions regarding Taiwan, and further turbulence emanating from these regions cannot be ruled out. But as for our portfolio, it is attractive.
Going into the Christmas season, we should like to wish our readers and investors a peaceful, healthful as well as prosperous New Year.
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This document has been issued by Aubrey Capital Management Limited which is authorised and regulated in the UK by the Financial Conduct Authority and is registered as an Investment Adviser with the US Securities & Exchange Commission. You should be aware that the regulatory regime applicable in the UK may well be different in your home jurisdiction. This document has been prepared solely for the intended recipient for information purposes and is not a solicitation, or an offer to buy or sell any security. The information on which the document is based has been obtained from sources that we believe to be reliable, and in good faith, but we have not independently verified such information and no representation or warranty, express or implied, is made as to their accuracy. All expressions of opinion are subject to change without notice. Any comments expressed in this presentation should not be taken as a recommendation or advice. Please note that the prices of shares and the income from them can fall as well as rise and you may not get back the amount originally invested. This can be as a result of market movements and of variations in the exchange rates between currencies. Past performance is not a guide to future returns and may not be repeated. Aubrey Capital Management Limited accepts no liability or responsibility whatsoever for any consequential loss of any kind arising out of the use of this document or any part of its contents. This document does not in any way constitute investment advice or an offer or invitation to deal in securities. Recipients should always seek the advice of a qualified investment professional before making any investment decisions.