After the dramatic events of last year, 2021 has continued in exuberant fashion for equity markets with the MSCI World Index already up 5% year to date. Headlines have been dominated by the extraordinary tussle between retail investors and hedge funds in stocks such as GameStop, the meteoric rise of Tesla, up eightfold in 2020 and now trading on a consensus price earnings multiple of 197x and $100bn in blank cheques written to special purpose acquisitions vehicles or SPACs. With interest rates still at historic lows and further monetary and fiscal stimulus on its way at the same time as Covid restrictions are likely to ease, there is every possibility that equities continue to melt up and push valuations to even more uncomfortable levels.
When selecting equities, we focus on three things. First is quality which is both the ability of a company to achieve sustainably high cash flow returns, but also the avoidance of uncompensated risk from leverage or poor environmental, social and governance practices. Second is the ability to grow those cash flows, particularly from structural rather than cyclical drivers. The final is valuation. In more euphoric times it is the last of these that is coming more into focus.
When looking at the value of our holdings we consider a variety of metrics including multiples of earnings or cash flow on an equity and enterprise level (including debt) as well as discounted cash flow models. Moreover, we do not consider those metrics in isolation, but in the context of the quality and growth that we are achieving. As such, while our portfolios often trade in aggregate on a slight premium to benchmark indices this is justified by the superior characteristics of our investments
Although we are long term investors with, on average, a holding period of five years, we are mindful of the need to protect against downside when valuations become excessive and avoid too much concentration risk as position sizes expand. As such, we have on several occasions taken profits in some of our strongest performing names, particularly technology in the summer of 2020 and more recently some of our holdings in industrials. We have also exited several names, including Remy Cointreau and Ansys where despite the quality of the businesses, the valuation was difficult to justify. We also do not invest at the more speculative end of markets, but only in business which have achieved positive cash flows.
While market commentators can focus on the relative valuation of regional markets, often with little regard to their underlying composition, we prefer not to select investments simply because the country in which they happen to be domiciled is labelled ‘cheap’. Instead, we focus on value in relation to a company’s true peers in terms of industry or end market exposure. Indeed, a way to address extreme valuations is look more widely within a sector for companies which may benefit from the same underlying trends but are at more palatable prices. An example of this is our exit from Experian, the UK credit bureau. With a scarcity of good quality companies in the UK market, the valuation had been pushed to a significant premium to international peers, especially TransUnion. The latter was a company which offered similar exposure to credit and risk management solutions with high barriers to entry and predictable revenue growth yet was trading on a sizeable discount, which justified the purchase.
We have also actively looked more for better valued opportunities in other regions and have recently made a number of additions in Asia. One example is NetEase, the number two video games publisher in China with over 140 mobile and PC games and a proven ability to develop premium content with lasting appeal. With the growth in expenditure on digital entertainment the company looks well placed, but was trading at a discount to similar publishers in the West.
2021 may turn out to be a year of market excess, but we will seek to protect the long term value of your investments by retaining a focus on quality, cash flow generation and actively managing valuation risk.
This document is issued for information purposes only. It does not constitute the provision of financial, investment, or other professional advice. The market review, analysis, and any projections contained in this document are the opinion of the author only and should not be relied upon to form the basis of any investment decisions. CCLA strongly recommend you seek independent professional advice prior to investing. Any forward looking statements are based upon CCLA's current opinions, expectations and projections. CCLA undertake no obligations to update or revise these. Actual results could differ materially from those anticipated.