By Rob Tucker, CEO of Chester Asset Management
Dispersion between growth and value stocksis near levels not seen since the dot.com bubble in 2000, even with the correction in the last quarter of 2018,. Growth stocks have run uncomfortably hard for the past 10 years, off the back of structurally lower interest rates and supportive central banks. And 10 years is an uncomfortably long time for value managers to be wrong!
The question is, should growth stocks be avoided at all costs with the market at these levels?
In our view, the answer is a simple – no. The main reason is because interest rates are not going anywhere in a hurry, and will remain at historically low levels for the foreseeable future, thanks to the US’s forecasted $35tr government debt along with the associated $1tr interest repayment cost. Simply put, the Fed cannot afford higher rates with its current and forecasted debt levels.
Low interest rates set a positive tone for investing in growth stocks. As a high conviction equity fund manager that focuses on growth at a reasonable price, we choose to keep the growth stocks that can benefit from key macro themes, such as technology, aging population and disruption.
One of the thematics that has gained increasing attention in our process, and from our investors, is disruption, and its association with the dispersion of returns between growth and value mentioned above.
To understand this, you first need to get your head around how companies are valued in the long term, and then extract how much confidence you have in the potential risk of that company being disrupted – well into the future.
Growth stocks, by their nature, ask investors to factor in value well beyond a traditional five-year cash flow assessment. We call this “terminal value” and express it as a percentage of earnings (cash flow) expected beyond a five-year view. The higher the terminal value of a stock the more confidence an investor needs to have that a company will not be disrupted. With the dispersion between growth and value at such stretched levels, there are more companies with high terminal values at risk of being disrupted before returning earnings to shareholders. But rather than screen growth stocks out, we keep them as part of our investment universe apply a rigorous disruption risk assessment process to ascertain where our levels of confidence are that a company will not be disrupted.
To get that degree of confidence we need to answer the following seven questions with a high degree of conviction that the company will not be disrupted, and therefore reducing the risk of disruption to its future cash flow.
7 questions assessing disruption risk:
- What is the risk of government intervention?
- Can the company pass on higher prices?
- Are assets/distribution channels easy to replicate?
- Risk of disruption over next 5 years?
- How concentrated is the industry?
- Can it grow more than 5% p.a.?
- Can it control input costs?
By way of example, CSL and Afterpay both present investors with high terminal values (86% and 93% respectively). Investors must make the assumption that both companies will be able to delivery higher cash flow well beyond a five-year view we have from today.
The graphic below shows Chester’s 7 question process in action and why, in our view, CSL is a growth stock with significant terminal value that we are comfortable to own because of its very low disruption risk. Whereas with Afterpay, we struggle to find a pathway for the company where it is not significantly threated by disruption in one form or another inside of five years.
So how does this stock insight provide value to investors in the Chester High Conviction Fund, distributed by Copia?
A significant benefit to the portfolio of this process and owning growth stocks with low disruption risk is a strong defensive capability. This is clearly shown by Chester outperforming the market in 83% of the months where the market has fallen.