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Perspectives

For better equity returns, focus on valuations—not growth

January 2017
3 mins. To Read

Growth has an almost irresistible allure for investors. Whether it’s a rapidly growing economy, a start-up with a hot new product, or a new industry that promises to transform our lives, investors are naturally drawn to opportunities that seem to offer the greatest long-term growth. Likewise, it is tough for most to envision a stagnant economy or a dying industry as a prime hunting ground for investment ideas.

History tells a very different story. Looking back over more than a century of data and across 19 countries, there is actually a slight negative correlation between real economic growth per capita and real equity returns. For example, even though Japan had the highest economic growth rate over that period, its equity returns were about half that of South Africa, which was the weakest economic performer.

How can this be? There are several reasons why economic growth and investment returns don’t necessarily move in tandem. In particular, competition may reduce profitability and excitement about growth may drive up valuations, both of which reduce future returns for shareholders.

The lesson is that the relationship between economic growth and stock returns is tenuous. Even if you were able to make consistently reliable macroeconomic forecasts—a big “if”—it would not be a guaranteed way to reap superior returns.

Instead, we believe it is far more rewarding to focus on valuation. Rather than starting with a “top-down” view of the world and making decisions about which countries or sectors look the most attractive, we take a bottom-up approach. Our analysts perform in-depth research on a wide range of companies, seeking to understand their intrinsic value based on long-term fundamentals. We then step back and ask ourselves which shares appear to offer the greatest dislocations between the market price and our assessment of their value.

This approach is by no means foolproof, but it puts us in a position where history can work in our favour rather than against us. The message from historical valuation data is loud and clear: one of the worst things an investor can do is to over-pay for stocks on the basis of unrealistic expectations. The chart below uses Japanese market data to highlight the long-term cost of paying too much for prospective earnings. It is based on monthly price-earnings ratios for the TOPIX from 1973 to 2006 and subsequent 10-year total returns, with periods grouped into quintiles based on their starting valuations.

The top quintile (primarily composed of readings from the late 1980s) has a staggering average price-earnings ratio of 47, with subsequent average 10-year returns of negative 3% per annum. Having underpaid for prospective earnings in the 1970s, investors overpaid for earnings growth in the late 1980s. Buying when the market as a whole was cheap led to better returns, but those opportunities aren’t always available.

The beauty of a bottom-up approach is that we don’t need to wait until a whole stockmarket is cheap.

Instead, we can select individual shares that appear to trade at a discount to their intrinsic value. That leads us to focus on individual companies’ fundamentals and valuations—not on divining the fortunes of whole economies. There are no guarantees of success, but the data suggests we are at least looking at the right things!

This Report does not constitute advice nor a recommendation to buy, sell or hold, nor an offer to sell or a solicitation to buy interests or shares in the Orbis Funds or other securities in the companies mentioned in it (“relevant securities”). It has not been prepared in accordance with legal requirements designed to promote the independence of investment research. Orbis, its affiliates, directors and employees (together, the “Orbis Group”) are not subject to restrictions on dealing in relevant securities ahead of the dissemination of this Report. Subscriptions are only valid if made on the basis of the current Prospectus of an Orbis Fund.


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