Global equities can rise by up to 75% over the next five years driven by profit growth, according to Knut Gezelius, lead manager of the Skagen Global fund.
Skagen is known for its active, value-based investment philosophy. But if you look at the largest positions of the global equity fund, you’ll mostly see prominent growth stocks such as Microsoft, Adobe, Alphabet and Mastercard. What happened?
‘We certainly do not only have growth stocks in the portfolio and still see ourselves as value investors, but we now call it applied value’, explains Gezelius. ‘Our selection process has changed. For example, we no longer use the price/book value indicator to identify new investments and we also attach less importance to the price/earnings ratio. Instead, we look much more at free cash flow’, he adds.
Intangible assets
The reason for this change is the increased importance of intangible assets, such as brands, patents, franchise agreements and digital platforms. According to Gezelius, international accounting rules do not take this sufficiently into account and are outdated. ‘Intangible assets are the driving force behind the growth of companies and they do not always appear on the balance sheet. As a result, the balance sheet and profit and loss account no longer reflect the true underlying value of companies. For example, companies that put a lot of money into internal software development will have an optically low profit and therefore an artificially high price/earnings ratio.’
Despite the strong bull market of recent years, Gezelius does not find equities expensive. ‘Although the global stock market is not necessarily undervalued in the short term after the strong rally since March, the valuations are not excessive either. Based on the free cash flow yield indicator, the market is trading roughly in line with the 25-year average,’ he says.
Gezelius still finds the upward potential for Skagen Global very attractive. ‘In the next five years the total return can easily reach at least 50% and even 75% is a real possibility based on the valuation of the fund’s current holdings.’
A further increase of valuations is not necessary to achieve the intended return potential, stresses Gezelius. ‘Our investments do not necessarily depend on higher valuations. We are more focused on generating free cash flow as an engine for long-term returns. The importance of valuing a company when it is included in the portfolio fades relative to the importance of cash flow generation as the investment horizon lengthens.’
Sceptical about value
The strong underperformance of value has been the subject of many a discussion over the past few years. For example, over the past ten years the MSCI World Value index has recorded a total return in dollars of 7.2% per annum on average. Growth stocks, however, have returned twice as much, with an annual return of 14.1%. But the significant underperformance of value stocks is no reason for Gezelius to switch from growth to value. ‘Value has lagged far behind and indeed looks cheap. But we have been hearing this argument for a few years now. So far it has been wise not to rotate. Trying to time the market, moreover, only yields disappointing returns.’
In addition, according to Gezelius, the question is why cheap value shares should suddenly perform better. ‘Will value catch up on the basis of historical outperformance and mean reversion? I doubt it. A fundamental driver that can start a rotation is needed and I don’t see this yet.’
European stock picks
The widely divergent performance of growth and value stocks has created a historically large valuation gap. While global growth stocks are trading at nearly 32 times the expected profit, the price/earnings ratio for value stocks stands at just 15.3. ‘Many investment experts expect value to outperform growth in a subsequent correction. But during the corona shock in March the opposite happened, with a dramatic underperformance of value compared to growth stocks,’ Gezelius notes. ‘This illustrates the structural shift in the fundamentals of the economy in favour of growth companies. As mentioned earlier, intangible assets make the price/earnings ratio less relevant and it can therefore be a misleading metric.’
The highly concentrated portfolio of only 34 names is almost 80% invested in listed companies in North America. However, many of these companies have a large international presence. On the basis of company turnover, the US exposure is about 55% according to Gezelius.
Europe is clearly underweight. ‘We are concerned about the economic prospects for Europe and would like to see more innovation and entrepreneurship. It is important to keep promising young companies here and not let them leave for the US.’
Yet the fund manager also sees promising stock picks in Europe. For example, he expects a lot from the Danish shipping company DSV Panalpina. ‘This company is not in charge of transport by itself, but acts as an intermediary between the carrier and the customer, and therefore has an attractive asset-light business model. Thanks to e-commerce, the growth prospects are excellent.’ Earlier this year, Gezelius also took a position in chip machine manufacturer ASML. ‘With its superior EUV technology, the company will retain its competitive advantage for at least another ten years.’