Why it’s not realistic to expect to get a good business at a low valuation

At a time when the so-called Magnificent Seven technology shares are trading at heady valuations, and US stock market indices continue breaking new record highs, Stonehage Fleming fund manager Gerrit Smit shares his views on why investors shouldn’t expect to get a good business cheaply and why he doesn’t believe in value investing.

Why do you believe you cannot get a good business at a low valuation?

Quality has a price, and growth investors should be prepared to sometimes pay rich valuations to participate in some of the world’s most promising companies. Most of my regrets involve not having been willing to pay up for some high-quality businesses with strong organic growth potential because I thought they were overvalued.

From my experience, you cannot expect to get a good business at a low valuation; you have to be realistic and willing to pay up for a good business on the condition of strong future growth. For example, we missed Apple 10 years ago because we were not convinced of its future organic growth and therefore thought it was fully valued, but the stock has done well since then despite low organic growth.

Why don’t you rely on value investing?

In a low-growth economic environment, such as we are currently experiencing, the typical value stock, such as a tobacco company, is trading at a low earnings multiple and a high dividend yield. Many value companies rely on strong economic growth to grow their business organically. In a weak growth environment their return may therefore be limited to the dividend income and investors may find little reason to believe in the capital growth potential. Instead, companies need to be in a growth industry or have a strategic competitive edge to be able to take market share, such as a talented management team, large scale or technological advantage to generate organic growth.

How would you suggest investors build a portfolio of best-of-breed, highest-quality growth businesses?

Based on my investment experience managing the Stonehage Fleming Best Ideas Equity Fund, I hunt for the “jewels” – quality companies that can indefinitely keep growing organically and are also attractively valued.

I’ve learned that it is crucial to identify proven businesses with a strategic competitive edge and a quality management team. We spend a lot of time trying to understand a business's culture and how management is orienting the business for sustainable growth over the long term. In essence, we look for the world’s best businesses that we can buy to hold indefinitely.

What are some of the quality businesses you hold?

Of the companies with the strongest growth prospects in the Fund are insurance broker Arthur J Gallagher & Co and technology businesses Alphabet, Amazon, Cadence Design Systems, ASML and Microsoft.

The stand-out performer this year has been Alphabet. It has been firing on all its business cylinders and recently unexpectedly announced its maiden dividend. Its solid performance has made it the largest holding in the Fund’s portfolio. Amazon also announced an excellent result from continued e-commerce margin expansion, accelerating AWS growth (from AI) and experiencing a sharp increase in free cash flow. Microsoft continues its strong performance, delivering especially well from AI in its Azure cloud business.

How do you know that buying quality growth businesses, rather than businesses trading at low valuations, has worked?

Since its inception in August 2013, the Stonehage Fleming Global Best Ideas Equity Fund has outperformed the MSCI All Country World Index. In 2024, many of our companies have announced stellar results thus far.

What are the greatest risks facing equity investors?

If I had to condense my concerns into a single issue, it would be the level of US inflation and by implication US interest rates. I emphasize the US because it often leads the other major capital markets. The growing geopolitical risks are also of concern. All said, investors rely on the quality of the management teams to lead their businesses in an ever uncertain global economy and we believe equities remains the asset class of choice for growing one’s wealth over time.