By Stephen Tong, analyst for the Mid Wynd International Investment Trust
The debate over whether time in the market beats timing the market has long divided investors. Those in the former camp tend to prefer an investment horizon measured in years, while those on the other side of the fence are likely to think in much narrower temporal terms.
The split is almost always stark, but sometimes the two worlds collide – or at least briefly align. This seems to be occurring now, with numerous high-quality stocks offering both the prospect of long-term profitability and a striking ‘buy’ opportunity that could prove relatively short-lived.
It is first essential to understand what we mean by ‘quality’ in this context. Simply put, these are shares in businesses capable of delivering high returns on capital and reinvesting at similar returns. Quality lies in ongoing growth and compounding cashflows over time.
Investors might reasonably expect to pay a premium for such companies, which normally trade higher than their market valuations. Yet today some of these stocks are instead trading as low as they did during the worst ravages of the Covid-19 pandemic.
How has this come about? There are several likely factors, the most significant of which is that these businesses have been buffeted by short-term headwinds and punished by the market as a result.
That punishment has perhaps been unduly severe. It suggests that in the era of the Magnificent Seven – the mega-cap tech stocks that have powered the S&P 500’s rise for more than a year – anything less than quarter upon quarter of conspicuously bold market guidance is regarded unfavourably.
Fears of recession might have a played a part, too. It may be too easy to overlook a stock – or to sell it – if the news flow surrounding it fails to produce a raft of positive headlines that buck the prevailing narrative of geoeconomic and geopolitical uncertainty.
Look more closely, though, and you find these companies have not experienced any notable decrease in return on capital during a difficult period. Their fundamentals remain sound. All that has really happened is that their valuations have become more attractive.
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Take Zoetis, the world’s largest producer of medicine and vaccinations for livestock and pets. Having reached nearly 56x at the end of 2021, its price/earnings (P/E) ratio stood at just under 33x in mid-June this year.
This dip may be in part due to safety concerns around Librela, an antibody therapy for osteoarthritis. Given that the drug has been administered more than 14 million times without a single report of adverse effects, our view is that such concerns appear unfounded. Zoetis continues to reinvest in research and product development, unlocking new market segments.
Bombardier Recreational Products (BRP), a Canadian business specialising in powersports products such as snowmobiles and all-terrain vehicles, offers another illustration. A weaker macro environment and higher interest rates have dampened demand in this arena, which is heavily dependent on consumer confidence and affordability.
Its P/E ratio hit a high of 35x in July 2020 and then tumbled in the face of coronavirus. It stood at below 9x in mid-June this year. Nonetheless, we think normal revenues will be restored during the next two years, with industry growth helping cut excess inventory.
What all this means, we believe, is that investors can buy long-term profitability much more cheaply than has been possible for some years. A recent analysis of our own holdings showed a 130% premium to the market in terms of earnings for a 45% premium in terms of P/E.
Of course, quality companies are unlikely to stay underappreciated forever. At some stage the wider market should recognise their enduring ability to generate both high returns on capital and solid operating cashflow.
Take software business Adobe, an established leader in digital transformation. The company issued underwhelming guidance earlier this year, when Q1 performance arguably failed to satisfy market hopes, and there have been claims that the company’s video-editing suite will face stiff competition from OpenAI’s new text-to-video package.
Adobe’s P/E ratio in mid-June was 50x – down from almost 67x near the close of 2021. Yet the company retains the air of a winner in the age of artificial intelligence and should benefit from an array of long-term trends. Q2 results were solid, rewarding patient investors.
More broadly, a greater number of investors may come to see the value inherent in such stocks in the face of declining interest rates. As the allure of high street banks and government gilts diminishes, it will be necessary to look further afield in the investment universe.
Eventually, the appeal of these businesses should become much clearer – at which point, perversely, their attractions will be less considerable than they are today. For now, though, they may represent as close to a timing opportunity as investors with long-term horizons are likely to encounter.
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