Equity markets in 2022 haven’t been kind to stock prices, with most sectors struggling as macro and world events have seemingly driven market movements.
For bottom-up investors, the environment has made it particularly difficult to trust that decisions based on fundamentals will be rewarded in the near future, but the market sell-off may provide a good opportunity for investors to back companies they are confident owning for the long-term.
Growth companies have been hit especially hard – many that had been trading at high near-term multiples have compressed significantly.
It’s understandable that investors have become less willing to pay more for growth with inflation high and rates rising, and it has been a popular topic of conversation to point out examples of even well-known growth companies now trading at P/E levels more associated with predicable businesses.
While the potential capital appreciation for many companies may be improved at recent price levels, fundamental investors still have to differentiate between companies that are simply cheap relative to recent history versus what they consider to be a fair intrinsic value.
Long-term investors expect that over a full market cycle, equity prices for strong companies that continue to deliver strong results will diverge from those that don’t.
Investors tend to use multiples with a near-term focus
Many fundamental investors rely on in-depth research and discounted cash flow (DCF) analyses to derive a view of a company’s intrinsic value, but multiple valuations can provide useful points of comparison and make analyses more robust.
Additionally, compressed multiples for many businesses help illustrate why the sold-off market might provide a great opportunity for bottom-up investors to invest in companies they think will perform well into the future.
Multiple valuations are an effective tool to assess company valuations relative to others, especially for those with similar profiles in similar industries.
Investors apply heavy scrutiny to the values used (estimated earnings or other measures, depending on the multiple), given single values have the potential to misrepresent or overly simplify a company’s future prospects.
For long-term investors, among the most important consideration when using multiples to value companies is time.
The multiples discussed most often are based on current or near-term inputs (Last Twelve Months or Next Twelve Months earnings, for example).
Even among knowledgeable investors, a relatively short-term focus is common, forecasting and applying a multiple a few years out. This illustrates the opportunity for long-term investors.
Invest in quality companies with a long-term perspective
Fundamental investors take solace in the fact that over an extended period time, stock price performance should track business performance, as the market is unlikely to maintain conservative multiples relative to a company’s industry and business profile if it demonstrates sustained performance and maintains strong forward prospects.
As has been stated within investment circles – time is the friend of a wonderful company, the enemy of the mediocre.
For great businesses growing at strong rates, beyond a few years, even high near-term multiples would compress to levels that the market is unlikely to sustain assuming the stock price is not going up sufficiently and the business quality has not changed.
Alternatively, for some of the growth businesses that have gotten walloped by the market due to concerns about slowing growth and now trade at multiples more associated with consumer staples, investors could expect the multiple to increase if the company can demonstrate that it maintains strong future growth prospects.
The trick, then, for fundamental investors is to find companies in which they can gain conviction and feel confident in its prospects through a market cycle beyond the short-term focus of the market.
And rather than focus on “long-duration” stocks with uncertain, far-off earnings that investors had rushed into and pushed to unsustainable multiples over the last 24 months, there are many companies of varying growth profiles at reduced prices that fundamental investors can pursue.
Different fundamental investors have varying approaches. One approach is to look for companies with proven business models and certain quality characteristics – like return on invested capital, attractive growth prospects, and durable competitive advantages – that when investors combine with their own in-depth research, can help separate companies they feel confident in projecting beyond the next few years.
Investing in the current market comes with the overhang of macro headwinds where even strong company stock prices might not perform well in the short-term.
However, for those that can remain disciplined and identify companies whose recent compressed multiples indicate prices at odds with a bottom-up analysis of a fair intrinsic value, investors can seek to benefit from the current bear market by putting capital towards companies they have confidence to hold for the long-term.
The opinions expressed are those of Matt Peden, senior portfolio manager at Invesco and as of 6/7/2022, are based on current market conditions and are subject to change without notice.