Investors should look beyond megacaps for fairly priced good companies

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There are many different styles or approaches to investing, but investors have historically separated themselves into two categories: one focuses on companies with higher levels of growth and one on the value being offered.

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Growth is typically easier to define because it’s based on a company’s ability to generate double-digit annual revenue increases with the expectation that will eventually translate into robust earnings. There are a lot of variables that can prevent these companies from achieving this goal and, therefore, investing in them is deemed to be higher risk, which makes sense given the greater return potential.

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Thankfully, the past decade of ultra-low interest rates and three rounds of quantitative easing have provided almost free capital for these companies to grow their operations. For example, before the rate hikes in early 2021, the average investment-grade company could borrow at a rate of 1.86 per cent for about nine years. Apple Inc. even issued a 40-year bond at 2.55 per cent.

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This allowed many companies to deploy what is called a loss-leader model, using this near-costless capital to build out a network, often called an “ecosystem,” by giving away a product or service at or below cost to rapidly grow and then layering in premium products or services to start making money.

Many of these companies are so large now that they have become tech oligopolies that put up protective moats around their networks, thereby preventing others from disrupting their businesses.

Value gets a bit trickier, but simplistically as a noun, it is something of importance, while as a verb, it is the act of estimating the monetary value of something. Value-based companies have been around for a while, but are often unnoticed because of their lack of excitement. They include traditional bread-and-butter sectors such as banking, energy, utilities, and some industrials and consumer staples.

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But just because something is cheap doesn’t mean it has value, and just because something appears expensive doesn’t mean it is lacking value. Or, as Warren Buffett famously once said, “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”

The problem is that computer-driven, momentum-based trading platforms can rapidly change the price of a company, thereby making wonderful companies no longer fairly priced.

Take Microsoft Corp. Ten years ago, it was trading at 2.5 times sales and 12 times earnings, and it delivered on the forward expectation for earnings and revenue. Fast-forward to today and it is now trading at more than 12 times sales and over 30 times earnings. Those are some mighty big growth expectations for a US$2.5-trillion company.

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To add some further perspective, the gap between value and growth stocks over the first five months of this year has widened to 23 percentage points, wiping out all of last year’s outperformance and registering the biggest divergence in 44 years of data, according to Bloomberg analysis.

Furthermore, the Russell 2000 Growth index is trading at a whopping 27.4 times earnings, 10 multiple points higher than the Russell 2000 Value index, which is trading at only 16.9 times earnings, according to Yardeni Research Inc.

Yardeni also shows that the eight megacaps in the S&P 500 are now trading at 29.5 times earnings while the S&P 400 mid-caps are only at 13.5 times earnings.

Looking ahead, we wonder how many of these growth companies and megacaps are going to be able to deliver on the forward expectations for revenue and earnings growth implied by their massive multiples, especially if interest rates remain at or near current levels.

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The good news is that there are a lot of good companies trading at fair prices, and you don’t have to look far, just a little outside of the megas that everyone is herding into. You may not even have to break out your approach by growth and value, but rather by what is fairly priced and what isn’t.

Perhaps it’s better to own a fair company at a wonderful price than a wonderful company at a ridiculous price.

Martin Pelletier, CFA, is a senior portfolio manager at Wellington-Altus Private Counsel Inc, operating as TriVest Wealth Counsel, a private client and institutional investment firm specializing in discretionary risk-managed portfolios, investment audit/oversight and advanced tax, estate and wealth planning.

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