Trending
Written by: Thorsten Winkelmann and Marcus Morris-Eyton
Equity investing is a learning process, in which portfolio teams must be highly disciplined yet always open to evolving. Here are some lessons that we’ve learned from investing in European and global growth stocks over the last two decades.
Remember What Really Drives Long-Term Returns
Earnings and cash-flow growth are the basic sources of long-term equity investment returns.
It may sound like a truism, but this simple principle is often forgotten in volatile markets. Over time, the performance of the MSCI Europe Index has closely tracked the earnings growth of its constituent companies (Display). And the MSCI Europe Growth Index, whose members have higher growth than the broad market index, has delivered even better returns. This suggests that investors who are able to identify companies with stronger earnings growth than the market tend to be rewarded with outperformance.
To do this, we believe cash flows should be prioritized in fundamental analysis. That’s because cash flows are the lifeblood of a healthy business and underpin a company’s ability to sustain earnings growth over time. Even when macroeconomic challenges and geopolitical hazards rattle market performance, equity returns over time are ultimately driven by a company’s underlying earnings trajectory.
Look Far into the Future
As active equity investors, we think a minimum five-to-10-year time horizon is optimal.
That may sound like an especially long time to project an investment’s future. However, we think this approach creates advantages for investors. It requires us to zoom in on business dynamics, which provide greater visibility of a firm’s earnings trajectory, no matter how volatile the surrounding environment may be. In a world of ever shorter attention spans, those with a very long view can benefit from what we call time arbitrage. That is, when a company’s shares are unfairly punished by the market because of short-term uncertainty, we can strengthen positions and adjust holdings with conviction in the long-term earnings outlook.
Think Like a Business Owner
Equity investors often buy a stock with a future sell date in mind. Business owners don’t do that.
Owners purchase a business to develop it, without a specified end date for engagement. With a business-owner mindset, investors will focus on operational attributes, such as the competitive moat around a company’s products and services or the corporate culture, and how they help support the sustainability of earnings.
This provides a very different perspective in which the fundamental business health is the highest priority. It can help investors filter out market noise that may distract investors from the essence of earnings success. And it can lead investors to companies in sectors and industries that aren’t always associated with growth potential, such as European industrials.
A business-owner approach can lead to even longer holding periods than our typical five to 10 years. In fact, select successful businesses may even deserve to be held in an equity portfolio for 15 or 20 years, which provides an added potential bonus of the compounding effect on returns.
Short-Term Volatility Brings Long-Term Opportunity
Equity investors with a strategic long-term view can take advantage of short-term volatility to bolster positions in stocks that are likely to recover over time.
Market volatility is a fact of life, and even the best managers will suffer a very bad quarter or year at some point. Of course, downturns and periods of underperformance can be unsettling. But before jumping to conclusions, ask why the portfolio has underperformed. If the portfolio team is disciplined in implementing its stated strategy and philosophy, don’t write it off. It’s far more concerning when portfolio managers chase crowds and fads with little strategic rationale.
Clients who develop a close relationship with portfolio management teams become partners through the ups and downs of market cycles; it’s easier for them to give a vote of confidence to a strategy during a rough patch. They’ll understand that periods of weakness don’t undermine an actively managed strategy. Good active managers will stick to their knitting through volatile periods and emerge with even stronger performance over a multiyear horizon.
The lessons that we’ve accumulated over the years are interconnected. When you understand the drivers of long-term returns, it makes sense to develop a five-to-10-year outlook. To gain confidence looking so far into the future requires the mindset of a business owner. And with that mentality, it becomes much easier to weather bouts of turbulence. Taken together, we believe these concepts can guide a portfolio to meet investors’ long-term financial goals with a compelling strategic investing philosophy.