With European markets trading at high levels, a rare window of opportunity is opening up for disciplined investors. After a decade marked by the distortions associated with negative interest rates and the rise of passive management, the valuations of quality companies are once again attractive, offering an entry point not seen for over a decade.
Good investors have one thing in common: discipline. They buy quality assets at reasonable prices. As soon as one of these two parameters is lacking, the investment turns into speculation and the calculated risk-taking becomes an uncertain gamble.
This discipline sometimes requires almost inhuman patience, as the financial markets are rarely prepared to satisfy the demands of the disciplined investor. More often than not, the best-quality companies are too expensive, and good prices reflect the mediocrity of the weakest companies.
Seeking to invest in quality companies at reasonable prices seems obvious in theory but proves difficult in practice. And yet this opportunity is now opening up in Europe, and you have to know how to seize it.
The business model of a quality company is as follows: steady growth in both sales and profits, financed by profitable investment and protected by barriers to entry that keep competitors at a reasonable distance. These barriers come in a variety of forms, including iconic brands, patents and network effects.
The valuation of some of these companies is finally within reach of the disciplined investor, although it will have taken more than 10 years. In mid-2014, the ECB embarked on a new and untried strategy, basing its monetary policy on negative interest rates. Instantly, the immutable rule of finance - a euro today is worth more than a euro in a year's time - became obsolete, because when interest rates are negative, the further away cash flows are, the more valuable they are.
An intellectual aberration that has turned into real dysfunction. Negative interest rates have led to the disappearance of the cost of capital, the restoring force that prevents the valuations of long-duration assets from soaring to irrational and unsustainable heights.
By their very nature, quality companies have longer than average durations because their cash flows offer greater visibility and resilience in the future. They have therefore reacted particularly well to this new situation. Their valuation premium relative to the European market has risen steadily throughout this period of negative interest rates.
In the non-discretionary consumer sector, for example (food, beverages, personal care products), which is characterised by above-average profitability and visibility, the premium has risen from 20% in 2014 to 70% in 2022, the date on which the ECB began to aggressively raise its key interest rate. In other sectors and for other 'quality' companies, this phenomenon has been even more marked, with PEs rising above 30x in 2022, compared with just 15x in 2014.
In addition to negative rates, another development has amplified these excesses: the rise of passive, thematic and factor-based management. These types of management have one thing in common: in their investment equation, the notion of a reasonable price does not enter into the equation. They only buy what has already risen, and keep the upward momentum going until rationality reappears, sooner or later.
In this case, we had to wait for the ECB to raise interest rates in 2022 and return to a more conventional monetary policy for the cost of capital to reassert itself and for valuations to return to reasonable levels. Since 20022, the share prices of these quality companies have been underperforming while their profits have generally been rising, as a direct consequence of their valuations having become unsustainable.
The same effects are now occurring in reverse. Passive and thematic managers are selling these falling share prices because their "momentum" has become negative. This is a godsend for investors who have remained disciplined. These companies, such as those in the medtech, consumer staples or drinks (beer, spirits) sectors, have retained their strengths and, for some, their valuations are once again very attractive. To take examples from the consumer discretionary sector, such as Diageo or Carlsberg, the valuation premium has fallen from 70% in 2022 to just 5% today, a 20-year low.
European markets are at their peak, but from the point of view of the disciplined investor looking for quality companies at reasonable prices, they are the most attractive they have been for 10 years. Patience has finally been rewarded, and the time has come to act and invest to take advantage. On this theme, Carslberg will benefit from the acquisition of Britvic, Pepsi's distributor in the UK, with good synergies and a 150bps increase in margin. Another example is Diageo, which is benefiting from lower marketing costs and whose margin is set to improve by 160bps.