Sharon Bentley-Hamlyn, Investment Manager and founding partner at Aubrey Capital Management, says:
The Aubrey European Conviction strategy has had yet another good year returning 25.2% year-todate to the end of November versus 18.1% for the MSCI Europe index. Over the past 5 years the strategy has returned 141.7% vs 49.8% and over 10 years 337.5% vs 135.2%. This has been an abnormally long cycle on any historic measure. Can it continue for yet another year? As much as we have confidence in the companies in our portfolios and applaud their efforts and financial results, we are not oblivious to market concerns.
We looked retrospectively at 2019 pre-pandemic valuation levels and discovered that the PE on the fund was actually higher than where it is today. The main difference is that in 2019, the average earnings growth in the portfolio was 20%, whereas the average earnings growth in 2021, on the basis of nine-month earnings, has been 115%, with just over 70% of the portfolio companies having reported.
This suggests a retrospective PEG of 0.4x in 2021 compared to 1.9x in 2019. In 2020, the pandemic year, EPS growth fell to around 15% and the year-end PE rose as high as 66x. This was of course an abnormality with the market anticipating recovery in 2021, which clearly we have seen.
You might say that it is forward looking PEGs that matter, and indeed, this is where we focus our analysis. In FY 2022 we are expecting growth in the region of 36%, which leaves the PEG at 0.8x, attractive on any historic comparison. The portfolio focuses on high growth areas and the PE reflects that, being twice the 14.6x PE of the MSCI Europe index, which represents the average for Europe’s quoted companies.
The average historic PE on the MSCI Europe index (since 1998) has been 23.4x, and the forward PE 13.8x (since 2005) so it is actually not so much higher than average currently. Compared to MSCI USA index at 21.3x, the European forward PE looks inexpensive. The portfolio’s expected forward EPS growth rate at 36% is 3x higher than the European index at 10.6% and 7.5x higher than the MSCI USA index at 4.8%.
Looking back on periods where a 15x PE was considered normal and one much in excess of 20x as expensive, interest rates were substantially higher. Could we return to a similar environment? It is worth reminding oneself that in the decade before the Global Financial Crisis the UK base rate was typically around 5% and in the 1980s it gyrated wildly from around 8% to as high as 17% at moments of stress.
At 15x the earnings yield would have been 6.7%, and if the interest rate was 5%-8%, 15x would have been understandable, and offered little by way of equity risk premium. So the question is really, what will happen to interest rates in 2022 and beyond, and will we have to discount future cashflows at a much higher risk free rate? We believe that with substantial growth still expected from the fund’s companies in 2022, the value of the portfolio is more than capable of holding up reasonably well with slightly higher interest rates. If we get a protracted period of high interest rates, the compounding effect will be larger, and it would be reasonable to expect PE contraction. However, thus far it looks as if central banks are set on keeping interest rates artificially low.
Even if one questions the central bank narrative that the current spikes in inflation are short term in nature, the members of the UK monetary policy committee will be keenly aware that even minor 2 December 2021 increases in rates will make government debt service costs prohibitive, let alone the 400-700 basis point increases of previous cycles.
How long their stance can persist is anyone’s guess. Logic suggests interest rates should be somewhere near the current rates of inflation which have risen above 6% in the US and to over 4% in Europe. In the end it may depend on whether buyers of government bonds will continue to play the game.