Value and growth traps: How to avoid both and beat the market

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Livewire Markets

Previously an actuary, Andrew Martin knows the importance of “valuing future financial risk" within investing better than most, especially in a world of relentless information flow and unexpected bouts of volatility.

“Whenever you think you are smarter than the market, you are probably wrong.” 

Alphinity Investment Management has never committed to being purely quantitatively or fundamentally-driven, instead, they derive the best of both to inform their decision making. This underpins Martin's focus on Earnings Leadership, a concept seemingly vacant from the broader market spectrum as P/E ratios balloon and investors display an unprecedented affinity towards high revenue multiples.

In this CIO profile, Andrew offers an insight into the apparent disconnect between equity markets and the economy, and the importance of balancing trust in your investment philosophy with evolving market trends. He also discusses how understanding a company’s story and underlying earnings quality is the key to avoiding growth and value traps.

Edited Transcript

How did you get started in investing?

A lot of people in this industry fall into it by accident, and I put myself in the other camp. I was focused on it right from school really. I was interested in investments and finance really from primary school. It all started with my dad. He had a whole load of these sort of odd lot shares that had come from spin-offs and stuff, and he gave all us kids some shares. It was literally 15 shares in a company called Romatex, a textile company in South Africa, which I knew nothing about. But I knew I had 15 shares and they were worth about 50 bucks and that was pretty exciting at the time, and I used to get home from school, read the paper, have a look at all the prices every day, see why it's moved, and of course it was the '80s, so it was going vertical, until it didn't in the '87 crash, and that was even more interesting to me. How's my net worth gone from 50 bucks to 25 bucks overnight? Anyway, I was really interested in what was going on. When we left South Africa a year later, I sold my 15 shares and bought myself a good old '80s boombox, which I had for years and years and I was sold.

So at school I was very focused on accounting and economics and those kind of things, and eventually I got a scholarship to go work and study at AMP and do actuarial studies up in Sydney, and that allowed me to work at AMP for a bit in the holidays while I was studying. And actuarial is all about valuing future financial risk, which is really a great setup for being an investment manager. When I worked at AMP after university, I was in life insurance, which set in my mind that I never want to work in life insurance as a career, but what I did do is it gave me a bit of access to the AMP Capital guys and that was really interesting to me, and so when I left, I went to Merrill Lynch. I did one of these internships, where you do a year and rotate through the different divisions. My first division was investment banking in the financial institutions group and I almost never left. Because I had actuarial background, they wanted someone that understood insurance, and so I stayed there for most of the time, except right at the end I got a little stint in their research team doing Banks and TMT, which is funny enough kind of what I do now, and that really got me excited, actually that's what I want to do.

Through my actuarial contacts, I got a job at JBWere, which was probably the preeminent research house at the time, as the assistant Insurance and Gaming analyst. I'm not quite sure why those two were put together. I think if you get given insurance they feel sorry for you so they give you gaming as a bit of excitement. And then I became the senior analyst eventually in that firm.

When Goldman and JBWere merged, I left to go and join one of my clients, which was AllianceBernstein, who was restructuring at the time. They had a few issues coming out of the tech wreck and September 11 and they were rebuilding the team, and so I joined, Johan Carlberg joined, who's now my partner in Alphinity, and a year later Bruce and Stephane joined, who are the other partners in the business, and that's how we met and got together.

Throughout your whole journey, has there been someone who shaped your philosophy in investing, and maybe even wealth overall?

There's been many people along the way. The senior analyst I worked for at JBWere, he was an actuary as well, but he taught me a lot about research and doing the nitty-gritty of accounts and going through those, so he was actually a bit of a forerunner in terms of how to analyse insurance companies in Australia and was definitely an influence in shaping me as an analyst.

Johan, who I work with now, when we got together he had a lot of investing background managing money here and offshore, which I didn't have. What I had was the quantitative analytical background, and so he taught me a lot about markets and what actually works in markets and we went through a whole process of putting our philosophy and process together, which was actually fantastic for me because it went from basic principles, “What works? How do we find that? How do we get these companies? How do we analyse them? What tools do we need?.”

We built it up from the bottom, and that in itself was just an incredible learning exercise.

Throughout this decade we have seen massive technological changes and structural shifts in monetary policy and fiscal policy, has this influenced your investment philosophy?

Our philosophy has actually been incredibly stable the whole time, and in fact, even going back to when we set it up in terms in 2003, 2004 as a team, I think it's survived the test of time. The way I think about it is that it is strict enough to keep you on track to know what you're looking for and what you're doing, but flexible enough to actually adjust when the market changes.

I know we've gone through a lot of crises, but big changes in what's driving markets actually don't happen that often or sustainably. 

There might be big sharp moves intermittently, but they don't actually happen in a sustainable way that often. But when it does, you need to be flexible enough to pivot, and our philosophy and process allows for that , so we haven't actually changed a lot in what we do.

I'd say we've learnt a lot in terms of how the stocks we look for adapt to different markets. You learn that all the time. But I think one of the great things of having gone through this long period and then the seven years before that, which of course came off the back of September 11 and the tech wreck, the rise of China, the GFC, so we had a bit of experience in that beforehand, was actually to trust the process, because it does adapt, it is flexible enough to move.

I always say to the guys, whenever you think you're smarter than the market, you're probably wrong, so don't try and second guess our process. We know it works, we know what we're looking for, focus on that, and we've seen it four, five, six, seven times come through different cycles now where it works really well, and if you stick to it, you're going to outperform through that whole cycle.

Do you feel there is a disconnect between a government-funded global economy and the pandemic?

There is a disconnect when you look at it from a top-down perspective, but that kind of disconnect isn't unusual in markets. Markets look forward, and typically economic factors are looking backwards, and so the market is trying to anticipate what's happening. So I'm not that surprised that there's a disconnect.

The size of the disconnect perhaps is surprising because it implies what has been priced in, so when I try and think about what this means in terms of where things are actually going, firstly I'll say I don't know. 

We don't spend a lot of time trying to think about is the market going up or down this week or next week. As far as we're concerned that's another thing to get wrong. There's a lot of assumptions we need to make and that's not one we need to base our portfolio on. We do it much more bottom up. But we care about what the market does and the drivers behind that.

The way we think of it is in a framework. To know where the market may go, we have to actually understand why it got here in the first place, and so you think about what's been driving the market to date, to this point, it's four things as far as I can see:

  1. Monetary policy: Interest rates are low, there's lots of liquidity around. Low interest rates do drive valuations, all else being equal. I'm not sure all else is equal, but they do drive valuations up. Lots of liquidity looking for a return, equity markets are liquid places to get return, so that's clearly been driving the market. Is that going to change any time soon? I don't think so. If anything, the feds told us it's going to be lower for much longer. We know all the central banks have signalled now, we all know that if there's going to be any kind of dip or volatility in the markets, they're going to step in, so that's not going to change.
  2. Fiscal stimulus: Unprecedented gets thrown around, but it's true. It's huge. And it's doing its job. It's actually holding things up in the economy. I think it's masking what's actually going on, but it's holding things up and there's likely to be more of it before it goes away. Again, is that going to change? It will. Eventually it'll fade off. As I say, I think there'll be more before it fades off, but it will fade off and then we will see what's actually happening underlying in the economy. But that's not going to change in the next few months.
  3. Economies opening up: Back from almost May, various economies around the world had their peak in infections and then they've started to open up. Even though we've had second waves and third waves and what have you, you look globally, things are still actually improving and still opening up. It doesn't feel like that here because we've got Victoria. 25% of our economy is in serious lockdown, and so Australia, which started off probably better than everyone else, is fading away now relative to everywhere else which is still opening up and still getting better. Citigroup has an economic surprise index for the US and it is off the charts at positive. So things are turning out better than people expected, and when that happens, it drives prices up. People get more excited about how things are looking. Again, is that going to change? I think that is one of the big unknowns. Is growth going to get disrupted? It's not quite a V shape, maybe a swish, but is that going to be disrupted at some point because of a second wave or a third wave or something else? Does growth just settle at a lower level than everyone expects? I think if any of those two things happen, that'll hurt the market.
  4. Vaccine: We were talking about this in the office the other day. I think it does seem to be that the market got to a point where it was just assuming that a vaccine is going to arrive by the end of the year, that vaccine is going to be rolled out really quickly and people will be travelling again next year and there'll be herd immunity within a reasonable amount of time.

Let's hope that happens, but we don't know that's going to happen and there has to be at least some probability that there's some hiccup along the way. I mean, we saw today a hiccup with one of the vaccines. So we don't know, but the market's kind of assuming that it's going to happen. Again, is that going to change? Well, we probably don't know until the end of the year, but any hiccup in that means the market's going to probably pull back.

So if we look at those four things in the next few months, it's hard to see much changing, but if I look into next year, you're going to have to expect some volatility because not everything's going to play out as positive as the market seems to be pricing in. If I look at market valuations in, let's go to FY22, when there's a bit more normal earnings, the markets looks pretty stretched, so it tells me a lot's been priced in.

That may happen, but the probability is something's going to come up and muck it up along the way. The way I think of it in that framework, it's hard to get too bullish the market from here. Again, I'm not massively bearish the market, but it's hard to get too bullish. I think what we more likely see is just a fair bit of volatility between now and into next year.

Could you describe this balanced approach you are taking, making bets if you're right but also hedging them in case a vaccine doesn't pan out?

As I say, the key thing that we've got going is, again, we never try and invest in something just to hedge something out. It has to have its own storyline, it has to have its own cycle going on.

Now, it is great if it gets the benefit of what's happening.

Fischer & Paykel is definitely a beneficiary of COVID. Ventilators are in high demand, they produce them, but as part of what's been going on, their nasal high flow product is also getting used more and being seen as a really good frontline usage and people are actually implementing more and more of their product and therefore there's a longer story, it's not just about COVID ventilators. Everyone knows that the ventilators are going to go up and down, but actually, there's something here that's going to be more long lasting. That's the thing we're looking for,

QBE is a company that's had a lot of issues in the last decade or more and just recently they actually lost their CEO. But before that happened, that CEO had been fixing up a lot of the issues in the business, so putting in much better underwriting practises, selling off the poor businesses and really setting the business up. Now, call it good luck, but what we're seeing now is pricing in that industry start to move quite significantly, and I covered QBE as a sell-side analyst back in 2000-2001, the last time this happened in a big way, and that was September 11 happened, because it was very similar. It had insurance companies struggling a bit because pricing had been poor for a long time. Suddenly you got this big event called September 11 and pricing took off. QBE raised money, had a fantastic almost six, seven years performance out of that stock. We then had 13-odd years of terrible pricing and now we've got COVID, and COVID is September 11 times a couple in terms of magnitude, and we're already seeing pricing start to move.

So with pricing starting to move, QBE set the business up in a way just to be able to leverage the benefits of that. That's kind of its own cycle. That's happening regardless of what else is happening now because the industry has finally turned the switch on, and so it's kind of everything that we're looking for. It's the markets underestimating the earnings expectations of their company. Because of their history, the valuation's actually pretty decent for QBE, unlike a lot of things in the market, and they have raised capital, so their balance sheet looks pretty good. So it's that kind of thing that we're looking for.

Macquarie, which we've spoken about before at Livewire, if anything, I think that the outlook looks even better. That’s been helped by what's happening because interest rates are going to be lower for much longer and that's really going to benefit their business. You would think, for example, that governments going into deficit are going to look to sell assets at some point, and infrastructure's a great one to sell, and Macquarie's got the capital there to help out, they've got lots of fire power, so that's all great. That's been helped by what's been going on. And then you've got on the side this green investment business that they've been building. They've timed it perfectly in becoming effectively the world's biggest manager, investor, owner, developer of green energy, and that's a freight train that's got its own momentum and it's going to keep going and they're right at the front of that. So again, benefiting from the environment but got its own story going on at the same time.

Could you explain what your investment philosophy is and how this has allowed you to consistently outperform while also managing risk?

That's by design. You got to go back to 2003 when we literally sat down with a blank sheet of paper and said, "Okay, let's design this, what works, what tools do we need?" And our first client was a life insurance company, took a very long-term view and they basically said, "Don't blow up. You don't have to be number one in the tables every month. What we want you to do is over a long period of time, just incrementally add value, and if you do that, you're going to be one of the better performing managers and you're going to do it with lower risk than everyone else."

So that was our mindset when we were trying to design this thing and put the tools in place. So risk became a big focus of this, how do we control risk?

With that as background, maybe I'll step back and say, what was our underlying philosophy when we looked at this? And our underlying philosophy, we call it Earnings Leadership. It looks at which companies in the market have earnings upgrades. Where's the momentum in earnings in the market at that point and can we find those companies?

I can assure you over just about any period of time through any different markets, if you can consistently invest in the companies that are beating market expectations on earnings, you're going to outperform. Now, finding those companies is hard, but if you can find them, and then if you can wrap that up with buying at a good price of value and overlaying it with quality, which is a risk control measure, we think you've got a winning formula.

So the way we describe ourselves is we invest in quality undervalued companies in an earnings upgrade cycle, and those are the three things we look for. 

So I'll take you through those three.

Undervalued: We want to buy companies at a good value, we want to get a good return. But there's actually more to it than that. Value's a really good risk measure. When you've got a bit of momentum, earnings momentum in your process, you really want a way of getting out, a good signal to tell you to sell, otherwise it gets quite enticing to hold really good stocks forever until they're not, and so value is a really good way of trying to stop you getting caught in the growth trap.

Earnings upgrade cycles (& avoiding growth and value traps):  We've all talked about the value trap a lot. Growth traps are worse. The growth trap is, you're investing in companies that are fantastic businesses, they're growing really strongly, everyone loves them, everyone's on board, and guess what happens? The P/E of the company gets higher and higher and higher, so more people get on board and think nothing's ever going to go wrong. And of course, something always goes wrong, and even if it doesn't go actually wrong, the market just gets ahead of itself, so they think this is going to grow 50% per annum forever, and maybe it grows at 30%, which is still great, but it's priced for 50. What happens then for growth companies is, so earnings come down, so you'll go, "Oh, I got earnings wrong," but then they say, "Oh, what P/E should I put on those earnings? They should be lower than I had before because I'm unsure about earnings now," so you get this double hit. You get earnings down, P/E down, and that's why when growth companies miss by 5%, they don't fall 5%, they fall 20%. And so missing that risk, that growth trap is key to us and we use valuation for that.

Go round to the other side is the value trap. So the value trap is buying really cheap looking companies and they just stay cheap because they're cheap for a reason, or they take forever to turn around. Who knows? We try and avoid that risk as well, and that's why we use earnings momentum. So we say, well, actually, has something changed in that company? Yeah, it's cheap, but has something changed? Where have the earnings gone? What are market expectations? Have earning expectations got down low enough that they can actually start to beat those earnings expectations? And if you actually wait for that, you miss out on a whole lot of risk of just sitting there underperforming for years and years and years.

And the reason it works is that once an earnings upgrade cycle starts, we get what's called zero correlation, so one upgrade is more likely to be followed by another one and another one and another one, and there's a whole lot of psychology and anchoring behind it from management of companies to fund managers to sell-side analysts, but you see that's why they call it upgrade cycles, because they go for a long period of time, and downgrades happen the same. So if you can actually wait and miss out on all that sitting around underperforming period, and admittedly, you might leave a little bit on the table, but you actually get most of the upside by then following the earnings upgrades. So our idea is, miss out on a growth trap, miss out on a value trap, invest in the middle in quality companies.

Quality: This is all about risk. Are the earnings that you talk about in valuation and in momentum, earnings momentum, are those earnings real, or are they made up, or are they a bit fudged on the balance sheet? It just takes out massive swings where you invested in companies that look really good but the earnings sort of evaporate. So quality is all about managing risk.

So I think if we can get those three things right, you're going to outperform consistently and through different cycles. And that's getting back to what I said before where it's a tight enough process to keep you on track, but it adjusts when markets adjust. When Earnings Leadership changes in a market, so suddenly the market goes from growth stock to cyclical stocks and it's sustainable, well, the process moves because Earnings Leadership changes and we're going to look for those companies now.

What do you think are the biggest growth and value traps in the market right now?

They change all the time, but there are a number of tech stocks, the obvious ones that we talk about on the growth trap side. Frankly, they could be there for a long, long time before there's any kind of wrecking, but again, we don't have any problem with the business models of these companies. These are great businesses, by and large. They've got great ideas, they've executed well, they've got a global potential market, so these are all great companies.

My issue is actually more about what kind of risk is being priced in and as we go day by day, less and less risk is being priced into these things, and I'm talking about from competitive risk to regulatory risk and to whether people are estimating their markets even correctly. And because all their value sits so far out, we're talking like an eternal value, 10, 15 years, because a lot of them don't make money now, so we're guessing long way into the future. Because we're guessing a long way into the future, small changes in assumptions make big changes to valuation, so that's why they're actually really volatile now.

Typically at the moment they're more volatile on the upside, but in the last two years, Afterpay's halved twice, look at WiseTech's volatility, Appen was 15% three weeks ago, they can be quite volatile, so I think what you want to do is you want to bide your time if you want to buy into these stocks.

The way I think about it is, if you want to with certainty price in massive assumptions in 10, 15 years' time, think about what's happened in tech in the last 10 or 15 years. 15 years ago there was no iPhone. Nokia was the king. This was 15 years ago. But we are being asked to price some of these companies on massive assumptions in 10 or 15 years' time in a tech market, with certainty? That's the bit I struggle with.

Funnily enough, I was questioning an analyst's fundamental assumptions and valuation technique the other day, and I was told in no uncertain terms that I just have to stop thinking like that because that's not the way the marginal buyer is thinking, which is revenue multiples. I must admit maybe I'm a bit too old-fashioned, but I do struggle with that concept.

There is a base valuation we need to think about, and the problem with using revenue multiples, or the like, is these stocks can halve and still look expensive. When you trade on 20, 30 times the revenue multiples, they could halve and you'd would still go "Wow, that's quite expensive." There's nothing there to back it up.

I would say though, just putting technology aside for a second, that we still look at it company by company, so we have owned some tech stocks. We have owned Appen in the past, we have owned Megaport, for example, but you do want to look company by company and make sure you can justify the valuations and bide your time and actually buy it at the right price, then you get a decent return without the volatility.

Something you believe in is using all types of research and not necessarily being hinged to a particular style (Growth vs. Value, Fundamental vs. Quantitative), so could you explain how the team puts an idea together?

As I say, we think back to the philosophy. It's quite a compelling philosophy, but the question is there, how do you find those stocks?

We take quite a pragmatic view right from the start, and I think it came from the fact that again, Johan had this really fundamental background, I had a bit of a quant-y background and when we came to sit down and say, okay, how do we find these stocks? Well, there's a lot of information out there, from fundamental analysis right through to quant side, and if you look across the industry globally, really, it's quite rare where people actually bring those together properly.

So after the GFC, a lot of quant funds turned quantimental. Because fundamental analysts are all biased and they've got an inherent issue with their research, so if you're a quant guy, why would you rely on that, and if you're a fundamental analyst, a pure fundamental analyst, you say, "Well, how can these quant guys really know anything about the... I do all this research on a company, there's no way they're going to know." So, sometimes you have screens on fundamental... Either side kind of doesn't like each other.

Our view was, hang on, there's a lot of information here. At different points in the cycle you can point to quant working really well here, and fundamental working really well there. Can we just bring the best of both worlds together? This whole man and machine idea, if you get the best of man and machine and bring it together, it works better than either one alone, and we kind of built that into our whole process from the start. I think trying to build that into a process into a company that hasn't had that before is really quite difficult, but we just started, so everyone who's joined the company, that's how it is.

And we don't see quant as this black box punching numbers in and it spits out stuff. That's not how we do it at all. We actually work the other way around. We said, okay, what works? Earnings upgrades, cash flow quality, price momentum, balance sheet accruals. We worked through things that actually tell us where they are in their life cycle, what quality balance sheet they've got and then we went and tested those to make sure they work through different cycles, and then we said to the team, in your fundamental analysis, don't just do fundamental analysis. Test it against the objective data. There's a whole lot of objective data telling you that you might be wrong. Well, don't ignore it, go and use it and say, "Well, okay, maybe I am wrong. What am I missing here?"

The great thing about having two sides of research or using the whole spectrum of research is that I may know nothing about Ramsey, let's say, but what I do know is I can straightaway pick up all subjective data that tells me a whole lot about where the company is in its life cycle and how it's going earnings-wise and balance sheet, and when Stuart, who covers our stock, wants to buy it or sell it, he'll come up with a view and he'll present it to the company, to the rest of the analysts, and I'll sit there and say, "Okay, that sounds really good, but what you're saying about earnings is completely different to what I'm seeing on an objective data. Why is that?"

Now, he knows how that works, so he would've gone and done that work already to work out why it's different and why it is sustainably different. Or put it the other way round, maybe it actually completely matches what he says and I say, okay, that gives me a lot of confidence that he's done a whole lot of work that matches objective data.

So what we find is, if you can get companies where both the fundamental agrees with quant, so objective and subjective information both say the same thing, and the more that they say the same thing, that's where we've got a much better chance of being right, that that company is the kind of company we're looking for about being in an upgraded cycle and sustainably so, and that's how we think about bringing it all together.

And again, to us, that actually creates a lot of the consistency that we have. Different things work differently at different points in the cycle, earlier cycles, growth cycles, core neutral cycles, but if you've got all the elements that you can play on and question yourself, if you can get the best of both worlds, it tends to smooth out the bugs. You don't have those big draw downs because you're not hooked to one style. What we're hooked to is Earnings Leadership and how we find that, we don't really care where information comes from.

Learn more about Andrew and Alphinity

Alphinity’s investment philosophy seeks to identify and invest in attractively valued, quality companies in, or about to enter, an earnings upgrade cycle. Simply put, they look for stocks that can deliver ‘earnings surprises’ to drive outperformance. For more information, you can use the contact button below or visit their website.

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