By Scott Ronalds

Our Global Equity Fund has had a poor stretch of performance since early 2010. The fund’s manager, Edinburgh Partners Limited (EPL), is the first to admit this. While they don’t manage the fund with a close eye on what the index is doing, any sustained period of under-performance is cause for concern. There are occasions when a dispassionate, comprehensive review is required. This is one of those times.

The manager recently prepared a detailed analysis that examines: (1) the portfolio’s structure and performance; and (2) market valuations. Here are the key takeaways.

Portfolio Structure and Performance

  • Investors have been focused on growth prospects in the developing markets. Specifically, companies with exposure to emerging market consumption and commodities have performed well. These companies have not been limited to the emerging markets, as a number of European and U.S.-based luxury goods, automotive and engineering companies have shown strong price performance.
  • EPL agrees with the consensus view that the emerging markets are poised to grow at a much faster pace than the developed markets. They believe, however, that the majority of companies were already pricing in this differential.
  • While companies with the highest growth rates may have good prospects, their valuations imply that their profit margins will continue to rise and sales growth will continue to accelerate. Yet, margins are already at peak levels and sales growth is likely to slow in a world with a significant debt overhang. Investors are thus paying a premium for growth and/or making unrealistic assumptions about what is achievable over the next five years.
  • The portfolio’s investments are concentrated in companies whose long-term forecasts are achievable in a slower growth environment. Included in this group are: (1) companies with attractive emerging market exposure that trade at reasonable valuations (Unilever, Heineken); (2) “mature” technology companies (Cisco, Applied Materials); (3) European companies in unfashionable businesses such as banking and insurance (UBS, Aviva); and (4) select Japanese companies (still viewed as the cheapest major market in the world).

Market Valuations

  • The portfolio currently has a pronounced “value” bias. It is concentrated in stocks with low price-to-earnings (P/E) multiples, low price-to-book value ratios, and slightly higher dividend yields.
  • The current structure reflects where EPL is finding investment opportunities today and is not how the portfolio will always look. In some periods, it will have more of a focus on companies with strong growth potential, if such growth is not being valued appropriately. EPL feels strongly, however, that investors are currently overpaying for growth. In fact, the portfolio exhibits the most extreme “value bias” in EPL’s history.
  • Importantly, although the portfolio has an extreme value orientation, it does not hold a large proportion of cyclical stocks (which include paper and mining-related companies, among others). Such stocks can exhibit volatile price swings.
  • Based on current valuations, higher growth stocks are trading at a 40% premium to value stocks. They will need to grow earnings at a higher-than-normal pace over the next five years to achieve fair value in the manager’s view. Value stocks, on the other hand, only require earnings growth of roughly half their historical long-term rate to achieve fair value, which would come with attractive price appreciation.

EPL believes that if their forecasts are broadly correct, strong absolute performance can be expected from the portfolio over the next five years. Valuation differences (between growth and value stocks) look to be particularly stretched and while the timing of the reversal can’t be predicted, history suggests that when the axis tilts, it can happen in a very short space of time.