Will the ‘quality’ investing style of Terry Smith and Nick Train recover?

Buying expensive but proven companies was once a sure bet, but rising interest rates is putting such stocks under pressure, Sam Benstead writes. 

For more than a decade, the most popular investment funds in Britain have invested in “quality” shares: companies that consistently grow profits and are very well established in their businesses sectors.

This means that technology giants such as Microsoft and accounting software firm Intuit, or consumer goods companies such as Unilever or Diageo.

The investment case, according to star managers Terry Smith and Nick Train, is that genuinely good businesses are extremely rare and it is worth paying a high price relative to profits to own a slice of a company that has captured a lucrative market and faces little competition.

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Once they’ve found companies they like, the favoured approach is to do nothing, riding a stock ever higher as it continues to churn out impressive and consistent profit growth.

Their success makes investing look easy. If all an investor had to do is find good companies and sit on their hands, then everything else – inflation, valuation, interest rates – can be ignored.

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But this investment strategy is facing a tough test this year. As interest rates have risen, investors have punished richly valued companies. Future profits become less valuable when the return from safe government bonds increases.

A decade of rock-bottom interest rates had pushed the valuations of Train and Smith’s favourite companies to extremes last year, with PayPal trading at 600 times profits and Intuit at 90 times, compared with an average of about 30 times earnings for the S&P 500 index in 2021.

Now with investors more focused on valuations, performance has struggled. Fundsmith Equity has lost investors 9% this year, while Blue Whale Growth, another “quality” fund with a growth bias, is down 19%. Lindsell Train Global Equity is flat this year having been down around 10% by mid-June.

In contrast, value-focused funds are performing well. Indexing firm MSCI’s All-World Value portfolio is up 6% year-to-date, while its “quality” global basket has fallen 6%.

Is this downturn in performance the beginning of the end of the road for an investment style that has had a great run, or is it just a healthy blip that will pave the way for another extended period of outperformance?

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Terry Smith not fazed

Despite poor returns this year, Smith is not blinking. In his half-year update to investors, he doubled down on his conviction that his investment strategy is superior to all the others.

Smith said: “Did we miss out by not owning more lowly-rated ‘value’ stocks during this period? Not much. The much-talked about ‘rotation’ from ‘growth’ to ‘value’ stocks during the first half of 2022 was rather underwhelming from the perspective of the latter.

“In the US, the S&P Value index did indeed significantly outperform its S&P Growth counterpart and the Nasdaq, but this outperformance took the form of a 12% fall for the S&P Value index versus a 28% decline for the S&P Growth index and a 30% decline in the Nasdaq.”

Smith argues that falling less than others when times are tough has obvious merit but that this still isn’t a sufficient payback for the long preceding wait during which value stocks underperformed massively.

He adds that many sectors he refuses to own, such as banks and airlines, actually fell by more than 20% this year.

Smith said: “In the US, the S&P Energy index increased 29% in the first half, while in the UK, BP (LSE:BP.) shares rose 17% and Shell (LSE:SHEL) 34%. For those regretting the absence of energy stocks from our portfolio, these increases have only taken the S&P Energy index back to a level it first reached in 2008 or the two UK stocks reached in the 1990s.”

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Quality that loves inflation

Stephen Yiu, manager of the Blue Whale Growth fund, says that valuations of companies got too high before 2022, so interest rates sparked a correction.

That reset was natural, he argues, and Yiu says that investors need to look through the interest rate rising cycle and hold on to stocks for five years or longer.

“Over longer periods, the growth in profits from ‘quality’ firms will pay investors back. In contrast, oil and gas profits are not sustainable as oil prices never stay high forever.

“Buying and holding oil doesn’t work, but sticking with ‘quality’ does. The valuation reset is a one-off unless you think rates [will] keep going up. Interest rates are cyclical, so long term, our strategy is still the right way to invest money.”

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Two quality stocks he currently likes are Mastercard (NYSE:MA) and Visa (NYSE:V). Yiu said: “This is a very high-quality duopoly. If we keep spending money, then much of it will pass through their network. They have a 50% operating profit margin and don’t need to increase cost base to make more money. The digital transformation away from cash still has legs, particularly in America, so there is lots of growth potential still.”

They are also an inflation hedge, Yiu argues, as they take a fixed cut of whatever people spend, providing a natural inflation linkage.

He said: “Revenue goes up with inflation, so they can keep growing revenue, at perhaps 10% a year at Visa and 15% at Mastercard. This is very consistent and there are hardly any disruptors.”

Trust in value’s long-term record?

Andrew Williams, investment director at fund manager Schroders, argues that the long history of success for value investing means its return to form this year is not just a one-off.

The reason for this, he argues, is that human behaviour will not change, as there will always be fear and greed in financial markets. This, he argues, makes stocks fall too far and rise too high, creating opportunities for investors who can separate price from true value.

Williams said: “Most investors are trying to figure out what happens next, from inflation and the war in Ukraine to supply chains, but value investors aren’t trying to do this. We try and figure out what a business is really worth versus the price the market gives it. Only focusing on a company’s true value brings a different mentality when investing.”

He says the success of value investing is clear in the data. “A value approach has outperformed the market if you look at 150 years of stock market data in America.

“The price you pay for a stock and the subsequent returns are correlated, going back to 1871. The flip side is that the more you pay, the worse your performance is. This data goes through tech bubbles, recession, tech disruption. It isn’t true every year, but [in the] longer run still holds true,” he said.

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Williams admits that there can be “value” traps – shares that are cheap for a good reason – but taking an active approach to fund management can weed these out.

The value investment team at Schroders, which manages the Global Recovery and UK Recovery funds, undertake in-depth research on a company’s prospect once they have met a screen for cheapness.

The global fund likes banks at the moment, such as Standard Chartered (LSE:STAN), as well as strong brands that have come under pressure, such as Intel and GlaxoSmithKline.