Building a portfolio one stock at a time
It’s easy to get bogged down in current market dynamics when a lot of energy is expended on predictions, but Bob Desmond, Portfolio Manager of the Claremont Global Fund says it’s easier to look at a company’s competitive advantage in the long term.
One example is Google, which Desmond says has “completely revolutionised the internet and has a massive market share” and continues to deliver secular growth despite short-term trends in the market. At a 2 trillion market cap, he says it still has room to grow its earnings.
In this wire, Desmond discusses the three key drivers for market returns – valuations, interest rates and corporate earnings – and importance of that competitive advantage in a low growth deflationary world.
Transcript edited for clarity and length
Could you explain your three key drivers for market returns — valuations, interest rates and corporate earnings?
Let's start with interest rates. We've got the lowest interest rates in living memory, if you like, whilst inflation is sitting somewhere on 4 or 5%, depending on which number you use, and ... break-even inflation sits around 2.5, 2.6%.
In our models, we are thinking that we are going to see at least 100 basis-point pick-up in rates or more, given where we are today. That, I think, is a headwind for markets.
In terms of the earnings growth, it's been really impressive. We've just gone through another earnings season. And, obviously, there's been some sort of supply bottlenecks.
But if you look at the level of demand and look at parts of our portfolio like Microsoft and Alphabet, and just keep delivering in terms of their numbers, our consumer stocks are delivering. So earnings growth is good.
But arguably you could say that profit margins are elevated relative to history as well. And so are market multiples relative to history as well.
I mean, the S&P500 is sitting at 20, 21 times earnings. So I think it's going to be hard to get the returns we've got from the market in the past. And you're just going to have to be very, very selective.
How useful are traditional market metrics (CAPE, Buffett indicator) in today's unprecedented environment?
I've been a fan of both for a long period of time. And they haven't really worked, both on CAPE (cyclically adjusted price to earnings ratio) and the Buffett indicator. I think from a common sense point of view, they do make sense.
The valuation of the market relative to a long-term earnings measure adjusted for inflation does make sense to me, to some degree, as does the valuation of the market relative to market cap. So theoretically, they sound good. But empirically, over the last decade, they just haven't worked.
I think there's an easy way to think about this. Just think about the psychology of the market. It's so much easier.
And you can see, just look around you. Look at house prices. Look at Tesla. Look at Bitcoin. Wherever you want to look, investor psychology is very, very bullish. And when it's like that, you're not likely to find bargains.
Why do you focus on companies over macro debates in your investment philosophy?
If you had said in 2007 that interest rates would be where they are today, and people think it's normal that the Fed is printing $120 billion of QE (quantitative easing) every month, people would have locked you up and put you in a straitjacket.
I've heard the value is going to snap back for a long period of time argument. It hasn't. I'm sure, at some point, it will. I guess we just don't take a view because these things are hard to predict.
I know a lot of energy is expended looking at markets, looking at themes, looking at economics. But from our viewpoint, it's so much easier to look at a business and just say, what's this business's competitive advantage? What do we think that competitive advantage will look like in five years? What are the earnings going to be in five years? And what's a reasonable multiple to put on those earnings?
That is so much easier. A lot less exciting. I mean, predicting markets and themes and valuations is where we spend all our time. But your probability of being right, for most investors there, is very low.
Do you protect yourself against any outcomes that could arise from these market issues?
You'll never find us starting an investment meeting with inflation numbers or Chinese production numbers or whatever the Fed said lately.
One of the examples I like to give to clients is: I think there have been 138 meetings of the Fed since Google listed.
And think of all the energy that's been expended every time the Fed speaks. And everyone looks through the minutes, and what does this word mean exactly? What is transitory, transient?
All you had to do was, say, look at the search engine. It has completely revolutionised the internet. It is the gateway to the internet. It has massive market share. It is so much easier to analyse that than what's going through the central bank governor's head. And that's why I just find looking at businesses easier.
But to answer your first question, we try and hedge our bets a bit. If you look at the portfolio, we have businesses that have secular growth.
So let's say we are in a low growth world. Well, over the last five years, the organic revenue growth of the businesses we own has been around 7%. So I think the portfolio is positioned to give you natural growth if we are in that low-growth, deflationary world.
However, let's say we are in the high inflation world, and we are moving into a new era. The portfolio has a 55% gross margin. So we have serious pricing power. The average listed business has a 30, 35% gross margin.
So we've kind of got a foot in both camps, if you like. What we are trying to do is buy businesses that have top-line secular growth and high margins and pricing path.
How much room for growth is there left for Alphabet?
I guess you just have to look at the last results. So for a $2 trillion market cap, for most of their core divisions. If you look at Google Search, YouTube and Cloud, they're all growing high 30s, over 40%.
Alphabet are still growing very nicely. Now, built into our numbers, we think that business can easily double their earnings over the next five years.
That's three times, roughly, of what the market's going to be growing at. If you take the total valuation of Alphabet, the group, and you strip out the cash they've got and adjust for the loss-making businesses, they can't be worth a negative value.
For core Google, you're paying 24 times earnings. Now I can find lots of listed businesses where organic growth is probably 5 or 6% that are trading north of 40 times earnings.
So relative to what else is on offer out there, I still think you're not paying a huge amount for the growth that you're getting today.
Obviously, in the future, if that growth slows, we'll adjust then. But as we stand today, they're delivering unbelievable growth and their competitive advantage is getting deeper.
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