The Ninety One Global Quality Equity Income fund manager says quality growth is worth paying for in this environment, but that doesn’t mean you can ignore valuations.

Investors looking for quality growth stocks to hedge against inflation should beware that they won’t hedge against this scenario if you pay too much for them.

That’s according to Abrie Pretorius, fund manager of Ninety One Global Quality Equity Income.

Pretorius itself uses a quality growth approach, which means it prefers to own small capitalization companies with intangible assets that allow them to offer a high return on equity and return cash to shareholders. in the form of steadily increasing dividends.

While these have done well in the decade or so to early 2022 as inflation remained subdued, Pretorius said these stocks should also continue to outperform now that this metric is on the rise.

“If you think about what you really want to own during times of inflation, obviously you want companies that have pricing power,” he said.

“People usually say ‘capital-intensive companies are the best’ and yes, during early periods of inflation they do well because they have natural pricing power.”

However, the manager said what investors miss is that if inflation persists, as revenues and profits rise, cash flows must be reinvested in investments. This is where the argument falls.

“If you’re building a mine or a factory, the payback cycle is about 10 to 15 years, so it’s going to take some time to adjust,” he continued.

“If inflation is persistent, say 15% per year for 15 years, a capital-intensive company will generate twice as much free cash flow as a capital-intensive company.”

However, value investors are far from convinced by this argument for quality growth.

Vitaliy Katsenelson, managing director of US-based Investment Management Associates, recently drew comparisons between today’s quality growth stocks and the Nifty Fifty blue chip group of companies – including Coca-Cola, Disney, IBM, Philip Morris, McDonald’s and Procter & Gamble – in the early 1970s.

“Although today we consider some of them to be has-beans, in the 1960s and 1970s the world was theirs,” Katsenelson said. “These stocks were one-rule stocks – and the rule was: buy!

“They were big companies and how much you paid them didn’t matter. [But] if you bought and owned Coke or McDonalds in 1972, or any other Nifty Fifty stock, you’ve had a painful decade with no return. It took until the early 1980s for investors who bought Nifty Fifties at the top to break even. And this applies to almost everyone.

For example, in 1973, McDonald’s had revenues of $583 million and had a price-to-earnings (P/E) ratio of 43. Yet Katsenelson said that if you had bought then, you should have waited 1983 for the breakeven share price, because although earnings had increased to $3 billion, its P/E had fallen to 16.

For Coca-Cola, the wait was even longer – in 1972 it had revenues of $1.9 billion and a P/E of 47. If you had bought back then, you would have had to wait until 1985 for the stock price to break even, because although revenue had reached $7.9 billion, its P/E had fallen to 16.

Share performance

Source: Investment Management Associates

“What the Nifty Fifty has shown us is that company greatness and past growth is not enough,” Katsenelson added. “The starting valuation – what you pay for the business – is important.”

Although Pretorius was not a value manager, he agreed with Katsenelson’s point of view to some extent.

“The assessments were wrong,” he said. “This is where dividend growth is quite interesting. Let’s take the two extremes of the spectrum: first, classic value, which really depends on high and sustained inflation, because that’s the only way these companies grow. »

Pretorius said “time is the enemy of these businesses” because the longer it takes for the multiple to revert to the mean, the worse your performance will be.

At the other end of the spectrum is classic growth.

“The risk here is that you fall in love with the business and believe in a dream that they sell you in 20 to 30 years and in times of growth uncertainty you have hope,” continued Pretorius.

“Now the beauty of dividend growth is that there is quite a strong valuation discipline and so you have to be more sensitive to that. Therefore, you can almost find the optimal mix between already strong companies that can s ‘accumulate at attractive rates and decent valuations.

He added: “So yes, valuation is a key part of this strategy and that’s why a dividend yield at or above the market is quite important.”