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Send  Share  RSS  Twitter  23 May 2011

INVESTMENT: Get the Growth Without the Multiple


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Dr Adrian Saville, CIO of Cannon Asset Managers, looks at ways to overcome the curse of overpaying for growth

In his State of the Union address in January this year, US President Obama noted that for the US to “win the future” it needs to “out-innovate, out-educate and out-build the rest of the world.” This notion implies that the countries of the world are engaged in a “win-lose” or zero-sum game. In President Obama’s version, the US can only “win” by “beating the rest of the world”.

Whilst this view can be understood from an emotive perspective, it does not hold water when viewed in light of the evidence of global prosperity. Through a broad sweep of time, the evidence we have is that as countries have advanced and moved up the income scale, this gain has not involved a downward move for others. Rather, a global middle class is burgeoning as a result of increased world trade. Art Carden writing for Forbes about the State of the Union speech said the “address conveyed an incorrect zero-sum worldview in which what others gain comes at our [the US’s] expense”. As economics has shown over and again, international trade creates wealth. The same follows from international capital flows, including foreign direct investment.

This “win-win” argument can easily be evidenced by anecdote. In the two decades before World War I the world economy enjoyed rapid expansion that was associated with vigorous gains in international trade and brisk growth in foreign investments. Between the end of World War I and the end of World War II, however, countries turned inward in a xenophobic-styled reaction to war. The result was a rapid slowdown in global economic growth, sluggish gains in international trade and a retrenchment of foreign investment. By contrast, the “golden age of capitalism” that followed World War II saw a reversal in each of these patterns: capital flowed more smoothly across borders, trade between countries grew quickly and the world economy enjoyed its greatest expansion in modern times. In short, the example illustrates that voluntary exchange is a positive-sum game. Bringing this argument into today’s setting, if the Chinese economy growths this doesn’t imperil our ability to get richer, too.

An example of the win-win potential emerging from China’s growth comes from that country’s cinema industry: China has been adding four or more new movie screens per day to its total of over 6,200 screens. This means that Chinese cinema owners are buying digital projectors, screens and other equipment and technology, often from US companies that are industry leaders, such as Ballantyne Strong, RealD and IMAX Corporation.

There is more to come. China’s box office grew 64 percent in 2010 to $1.5 billion, on top of more than 40 percent growth in 2009. The Chinese market is expected to reach $7.0bn and 20 000 screens by 2015 with positive implications for equipment and technology firms that supply the industry, regardless of their country of origin.

Taking the argument back to the US, the issue is not so much that manufacturing in US is dying as it is changing. In fact, the US remains the world’s leading manufacturer. According to Bank of America Merrill Lynch, if US manufacturing were a national economy, it would be the eighth largest in the world, worth $1.6 trillion a year, while the Cato Institute has noted that for every US manufacturing industry in decline there are two that are growing.

Industries in the ascendency are those which gain the most from global trade, notably materials and technology. In these two instances, foreign sales of US materials and technology firms account for over 50 percent of total sales (see Figure 2). Close behind is the energy sector which exports some 48 percent of sales. Significantly, there are US companies which are benefiting from global – and especially emerging market – growth but which do not trade on high multiples. Thus, one can access the prospective growth without paying a high price.

To this end, research undertaken by Benjamin Graham and David Dodd in the 1950s pointed to the use of Cyclically Adjusted Price Earnings (CAPE) ratios to indicate the relative value of equity investments. A CAPE ratio in excess of 16 indicates that a share is overvalued, while a CAPE ratio below 16 points to value. Importantly, this figure of 16 times is not random: it translates to a real yield of about 6 percent (before any growth from earnings power).

We have found that the CAPE ratio is as effective an indicator of value at the country level as at the individual stock or sector level. On this basis, the Chinese market is severely overrated on a CAPE ratio approaching 30 times (see Figure 3). By contrast, the ratings of Russia, Spain and Italy are reflecting considerable value on multiples of 9, 12 and 10 times, respectively.

Perhaps more importantly, within each of these countries, there are companies which are trading on low CAPE ratios, but which are exposed to global markets. These companies are priced for the prospects of the local market, yet are exposed to global growth. For example, while Spain is on an already tempting CAPE ratio of 12 times, Santander Bank which is driven to a large extent by Latin American performance is on a mouth-watering CAPE ratio of nine times and trading at less than book value. In Italy, with the market on a CAPE ratio of 10 times, a company like Benetton can be bought on a dividend yield of just less than five percent and a price-to-book multiple of 0.5 times. Importantly, 65 percent of Benetton’s sales take place outside of the country. In this vein, Lukoil, one of the Russian oil majors, is priced on a CAPE ratio of six times with an exceptionally strong balance sheet. The price-to-book multiple of less than one makes this cash-rich oil firm an excellent prospect in a world of buoyant and rising oil and gas prices.

Financial history is littered with examples of investors confusing economic and company growth prospects with potential investment success. The reality is that there is almost no correlation between the two. In this vein, Jay Ritter observed in 2005 that “… economic growth rates are … irrelevant to stock returns”.

By seeking out value – both at the country and the stock level – investors can enjoy substantial investment growth by overcoming the trap of paying for growth.

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