Focus on quality and value will take care of itself: What matters more than a firm’s valuation
Recent market volatility may have some investors concerned by falling valuations, but it’s important to focus on the quality of a business, according to one of Britain’s top fund managers.
Mark Slater co-founded the specialist UK equity fund management business Slater Investments in 1994. He’s ranked third out of 186 UK equity fund managers over the past year according to Citywire’s league table, with a total return of 28.1 per cent compared to the fund manager average of 11.6 per cent.
His managed funds have also won plaudits. Investment magazine Money Observer picked Slater Income as one of its top 14 funds of 2017, and in 2016 it selected Slater Growth for the best larger UK growth fund award. Slater Growth returned 25.84 per cent between January 2017 and 2018, according to the fund’s most recent fact sheet.
Slater explained his firm’s management approach doesn’t favour large or small caps, but looks across the whole market.
“It’s fair to say the greatest upside comes from small- and medium-sized companies, simply because they can multiply their size many, many times. If you get it right, the upside is greater,” he told City PM during a phone interview.
“We don’t only look at those; we look right across the board and there are times when larger companies are very attractive from a valuation point of view.”
The firm makes investment decisions based on three criteria. Firstly, a company’s ability to grow its earnings. Secondly, whether that growth is relatively cheap for investment, which is measured using the PEG ratio (the company’s price-to-earnings ratio divided by its growth rate). Lastly, they examine the company’s cash flow.
Read more: Investors are less worried about an equities market meltdown in 2018
“We look at cash flow in two ways. One is whether profit is being converted into cash, which is a very good measure of whether profit is real,” Slater explained.
“The second aspect of cash flow is the degree to which companies generate free cash flow. Most businesses we tend to end up investing in are very cash generative and don’t require high levels of capital expenditure.”
This method allows Slater and his colleagues to dismiss 95 per cent of the market.
“Most companies are not growing at an interesting rate. If they are they’re often very expensive and often they don’t generate cash flow or there are problems with the accounting,” he added.
“If you find a business that is growing at a good rate, you can buy relatively cheaply and is generating cash, the odds are you’re going to make money.”
Slater added that it’s important to understand the dynamics of a business, such as the challenges it faces and identifying what tailwinds are driving long-term growth.
This approach of focusing on the quality of the business has helped Slater deliver returns even during tough periods of the market. He gave the example of the 2007-08 financial crisis.
“We did an analysis in October 2010 of the holdings in our growth fund compared with October 2007, which was three years before but also the peak of the equity market prior to the global financial crisis, which was a pretty serious bear market by any measure. The system nearly failed. It was a very, very severe test.”
This analysis revealed that of the companies they owned in 2007, the worst one had grown its earnings by almost around a third over the three-year period. The best had grown its earning much faster at more than 150 per cent over the three years.
Read more: Stock markets remain in volatile mood
“Clearly during that three-year period there was a very severe drop during 2008-09, but by October 2010 the share prices had sorted themselves out and they were all nicely up, broadly in line with earnings. If you had fallen asleep for that three year period and woken up in October 2010, you wouldn’t have known what the fuss was about,” he said.
“If you’d sold at the wrong time you would have lost a lot of money, but if you just held on and had faith in the quality of the businesses, you’d have done perfectly well.”
Slater found a similar occurrence following the Brexit referendum.
“Some of the businesses we own are international, but the more UK-centric ones were hit very hard. Some of them fell 30, 40, 50 per cent for a short period, but over the course of the second half of 2016 and 2017, they did really well,” he said.
“The businesses did well and the share prices re-rated really quickly. What matters is the performance of the business. Valuation is less important than the quality of a business.”
Slater will be attending The Global Group UK Investor Show in April. He praised the show for being very well organised.
“They get a great turnout and it’s nice to see so many private investors taking investing seriously. That’s always impressive and there’s a great deal of enthusiasm,” he said.
He will also speak during the event.
“I typically focus on ways in which one should think about investment and I normally talk about a number of companies that illustrate those points.”
To claim your free Investor Class ticket for The Global Group UK Investor Show on Saturday 21st April 2018, visit www.ukinvestorshow.com/tickets and enter CITYAM as the discount code.