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A swift glance around the playground at the start of a new school term reveals a great deal about expected growth rates and time horizons. Some kids wear jumpers that are brand new but several sizes too large. Others sport older pullovers that fit tightly over rapidly expanding frames. Very few uniforms fit perfectly. Rarely do parents perfect the trade-off between futureproofing for anticipated growth spurts whilst ensuring that their childrens’ jumpers don’t resemble dresses in the meantime.
In many respects, equity multiples are rather like those school jumpers. And in recent months, the market has been badly struggling to fit multiples to stocks, based on their individual growth expectations. It appears to have given up, removed the jumpers, taken them to the cleaners and stuck them on the same wash cycle. And it’s a hot wash. The woollens (a tad pricier up front in anticipation of longevity) have shrunk the most, while the viscose and polyester have held up a bit better.
But as they’re handed back to the school kids, there’s now a big disconnect between the new jumper size and the requirements of their occupants.
The table below shows the extent of this disconnect on a backwards-looking basis for a handful of stocks that we own across various Baillie Gifford portfolios. It’s a largely random plot, with little correlation between delivered growth rates and recent share price performance. But if there is a pattern, it is that the faster-growing stocks have fallen more over the last 12 months.
Operational growth disconnected from share price
We should be wary of spending too much time ascribing reason to this strange market irrationality. There are many black boxes and algorithms at work. But the most logical explanation is that faced with emergent inflation, the stock market is trying to work through how much of an inflation adjusted discount it should apply to future cashflows.
In other words, the market is grappling with the right ‘new normal’ multiple to attach to equities.
Based on a dataset spanning around 140 years of stock market history, students of CAPE (the cyclically adjusted price-to-earnings multiple used to evaluate whether markets are overvalued) will point to a long-run average of just over 21 times earnings.
They’ll also flag that when long-term interest rates have notched up to the high single digits, the market multiple has commonly fallen to the low teens. And during a couple of exceptional periods, including 1981 when interest rates rose to nearly 16 per cent, down into single digits.
Price-earnings ratio versus long-term interest rates
Given the highly uncertain macroeconomic backdrop, there is a wide range of market narratives on where the stock market might settle.
But we’re spending little time on this question. This is partly because we have little to add by lobbing our guess into the mix. But it is also because we don’t think that the ultimate market multiple will have a huge bearing on our ability to generate strong returns for our clients.
We hold this view because the remarkable arithmetic of compound growth, the eighth wonder of the world, means that there’s scope for great upside in structural growth stocks, even if Mr Market settles on a very low multiple for them. In other words, the amount and the duration of operational growth are more than capable of swamping multiple compression.
Three alluring inefficiencies
1. Illusory cliff edges
The first dislocation affects stocks such as Moderna and BioNTech. Both companies trade on low single-digit multiples of their current earnings streams. This is despite some of the most eye-watering levels of growth* that we have ever seen.
This is truly hard to fathom. The most plausible explanation is an assumption on the part of the market that their Covid-19 vaccine revenue streams will fall off a cliff edge in due course, with nothing to take up the slack afterwards. To our minds, this reveals a profound market misunderstanding, and an exciting inefficiency.
There is plenty of evidence that both businesses have a strong and increasing chance of growing at very high rates for a very long time due to the modular nature of their platforms.
Both companies are in rude financial health. Moderna has signed advance purchase agreements of $21bn, is throwing off circa $12bn per annum and carries $20bn on its balance sheet. These strong coffers provide the launch pad for the opportunities that excite us.
Moderna talks of building a ‘vaccine app store’ for all manner of diseases, from respiratory conditions to cancer to malaria. CEO Stéphane Bancel’s vision is that following a blood test at your local doctor, you return a week later to pick up a vaccine tailored to your unique epigenome.
BioNTech enjoys broadly similar financial characteristics but is looking to disrupt traditional pharmaceutical supply chains in a slightly different way.
The aim is to remove the local factors that govern where vaccines can be produced, with a modular shipping container facility that can be installed and run anywhere in the world. Updates to the production method or tweaks to the recipe of the vaccine itself could be transmitted digitally to any container in the network.
BioNTech is in discussions with South Africa, Rwanda and Senegal to have containers arriving by the end of 2022. Each set of 12 containers will need four or five operators and be capable of producing some 40-60 million doses every year. The production system could also make other vaccines and drugs, for example, against malaria or tuberculosis.
These transformational opportunities are completely passing the market by at present. A reversion to some fictitious ‘pre-pandemic mean’ is expected, reinforcing how little the stock market understands the massive shakeout to healthcare systems in the coming years. Remarkably, the big pharmaceutical companies command multiples three times higher despite the cataclysmic threats to their wasteful business models.
*39x YoY for BioNTech and 23x YoY for Moderna.
2. Long-duration infrastructure
The next inefficiency relates to the companies collectively installing the infrastructure for the next decade.
Let’s take a trio of slightly different examples in ASML, CATL and Adyen. Each of these companies is, in its unique way, in the process of laying crucial foundations for our economy.
ASML’s Extreme Ultraviolet (EUV) machines are of systemic and unparalleled importance to the future of chip design. ASML has over a year’s worth of backorders. Any escalation of tensions in Taiwan would likely further cement the company’s advantage given its foundational importance to semiconductor supply chains.
CATL, meanwhile, is solving the world’s most pressing problems in energy storage and resource intensity with its advances in battery technology.
Adyen is a younger company, but again, operationally blossoming as it develops the essential plumbing for the global currency transfer market.
All three of these companies (two Dutch and one Chinese) help to remove costs for their customers. They provide essential products and services. And, on that basis, it seems perfectly reasonable to expect their growth rates to hold up well over the next decade.
Now, we’d be the first to acknowledge that the road ahead is unlikely to be entirely smooth. CATL, for example, has just been hit by the double whammy of the ‘uninvestable China’ narrative and a transient growth air pocket of lockdown-related supply-chain issues.
But even if we assume that its growth rate falls by three quarters, and we throw in some additional earnings per share dilution, the company ends up on a single-digit multiple
of earnings in a decade from now.
In a similar vein, ASML and Adyen’s growth rates could more than halve from current levels with the same valuation outcome.
This exciting dynamic illustrates the great scope to make an awful lot of money from today’s starting valuations over the next decade, even if their multiples shrink from here.
The margin of upside for such holdings has rarely looked more exciting – a function of the market being so preoccupied with the immediate issues that it is completely missing the length of their respective runways for growth.
3. What is? versus What if?
Let’s now turn to another current valuation anomaly. It has arisen because the market is suffering from extreme ambiguity aversion. The market has an acute case of the Ellsberg Paradox, which is that it prefers known odds in the form of calculable near-term returns over the unknown odds of possible outlier scenarios.
Currently, little or no value is being ascribed to the potential fruits of experimentation or unique cultures – to growth that could be radial rather than linear. This presents a wonderful opportunity for investors prepared to shift from a ‘what is?’ to a ‘what if?’ mindset.
NVIDIA Corp, the interactive graphics chip company, is a case in point. It is priced on the basis that the current revenue streams (largely based on gaming and datacentre optimisation) will gradually saturate.
But NVIDIA’s capabilities underpin computational drug design, climate change simulation, speech recognition, automotive control systems, industrial automation and computer vision. NVIDIA is developing a systemically crucial role in these inestimably massive markets.
In our eyes, it’s perfectly plausible that NVIDIA’s strong growth rate will be sustained, via radial growth from the core, for many years to come.
So, once again, it doesn’t matter whether the stock market ends up trading on 15 times earnings, 10 times earnings, or even less than that – because in any of these scenarios there remains abundant potential to make a great deal of money.
NVIDIA’s growth rate always bobbles around wildly from one quarter to the next but to put things into context, if the company’s structural growth rate more than halves to, say 20 per cent pa, the company still ends up trading on a mid-single digit multiple of its earnings in 2032. So once again, there’s an abundance of headroom.
When investors look back in a decade, they might well be surprised to observe that back in 2022, NIVIDA’s market cap was a third of Apple and that the latter featured in many value portfolios. The benefit of hindsight might also reveal that the greatest risk, in retrospect, was a failure of imagination – an inability to imagine the scale and longevity of the earnings streams on offer to exceptionally adaptable companies.
The seductive perils of fixating on spot multiples
The examples above show why a slightly higher near-term multiple needn’t preclude transformational returns.
A related observation is that a low multiple of near-term earnings doesn’t necessarily mean that a stock is cheap. Capitalism is finally acknowledging that the corporate world is not separate from the natural environment but part of it. As a result, at some point within the next decade, companies are highly likely to be forced (either by regulation, consumer behaviours or a combination of the two) to account for their external costs properly. Corporate earnings streams will see a radical adjustment and approaches to valuations will need to respond.
This is problematic for the index because of its carbon intensity, particularly so for some of the traditional energy index constituents that have held up the best of late in share price terms.
As a case in point, let’s take ExxonMobil. The current multiple of 15 times earnings looks interesting at first glance. But that’s before we consider the almost entirely unpriced carbon in its value chain. This company’s transparency on emissions remains poor, but we know that its own operations emit 110 million tonnes per annum, and that the combustion of the oil and gas it produces, refines or sells emits at least 650 million tonnes (and most likely considerably more if we infer total emissions from the better reporting of many of its peers).
We don’t yet know where in the value chain of an oil major the impact of priced carbon will rest. Some will be in higher direct costs, some in lower prices, some in structurally lower demand. But, to be simplistic, even if we apply a relatively low carbon cost of $50 per tonne, there is at least $38bn of unpriced carbon in Exxon’s value chain – equivalent post-tax to 90 per cent of 2021 earnings, and implying a rather more expensive multiple of 190 times.
Surely Exxon could pass on some of these costs? Perhaps, in the short term, it could, but that would surely hasten the long-term demand destruction. Suddenly, the index looks a little less cheap and safe than presumed by a market that is currently unable to see beyond the fog of the moment.
Conclusion
Sponge wringers versus future proofers
Amid the current market melee, it’s all too easy to fall into a couple of traps.
The first is a failure of imagination. By focusing entirely on the immediate, the market has lost any ability to price future prospects. Yawning, once in a generation, valuation anomalies are emerging.
The second is a failure to distinguish between price and value. The traditional growth and value boxes have a lot to answer for here and they look increasingly limited. But what might the alternative boxes be for an investment consultant or asset allocator going back to first principles?
One suggestion would be to make a distinction between the ‘sponge wringers’ and the ‘future proofers.’
If you believe in a linear continuation of the current world and stasis, then there’s a rational argument for buying shares in the companies in the former category. Companies run with a 20th-century shareholder value mindset.
The sponge-wringing investors may well be able to extract some last drops of value from legacy incumbents in industries such as oil, utilities, pharmaceuticals and banks. But, to return to our school playground analogy, while it might seem their jumpers will fit them for many years to come, and in time may end up being too big for their shrivelling frames.
If you believe that the world will progressively change – technologically, geopolitically, societally, economically – and you want to be a part of that world, then you need to back the future proofers.
Investors with long-term, 21st-century mindsets should be seeking out adaptable companies. To find them, investors will have to be comfortable with uncertainty, have a high level of humility and to search for different perspectives.
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The views expressed should not be considered as advice or a recommendation to buy, sell or hold a particular investment. They reflect opinion and should not be taken as statements of fact nor should any reliance be placed on them when making investment decisions.
This communication was produced and approved in May 2022 and has not been updated subsequently. It represents views held at the time of writing and may not reflect current thinking.
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