As markets refocus on fundamentals, EQV takes the spotlight

Could we see an increased market focus on quality and valuation as the strong earnings upgrade cycle appears to fade?

As markets refocus on fundamentals, EQV takes the spotlight

Time to read: 2 min

Confidence in global synchronized economic growth has fostered a momentum-driven market since early 2017, with many investors buying companies with positive earnings outlooks but showing little regard for valuations. This type of market can be tough for the Invesco International and Global Growth team, as valuation is an important aspect of our Earnings, Quality and Valuation (EQV) investment process. In recent months, the market narrative has been shaken by concerns over trade wars, political uncertainty and a moderation in economic growth outlooks. We believe that portfolios built with our well-balanced EQV philosophy should be well-positioned to potentially benefit when the market refocuses on quality and valuation.

An EQV assessment of recent market performance

The Invesco International and Global Growth team follows a bottom-up approach that focuses on EQV characteristics — so how did the various components of our philosophy perform in the second quarter?

Earnings. Recent equity outperformance has been driven by high momentum and high earnings growth expectations. This recent market behavior could be characterized as “unsustainable performance-chasing” with limited regard for valuation. History has shown that chasing high expectations often ends badly when the market turns and businesses fail to deliver on overly optimistic expectations.

Quality. The market tends to favor high-quality businesses when earnings visibility is reduced. In line with the theme of a less certain growth outlook, we began to see improved performance across our holdings with high-quality stable earnings outlooks and US dollar exposure. European examples include some of our long-term holdings such as SAP (a dominant provider of enterprise resource planning software), Informa (an events and publishing company), RELX and Wolters Kluwer (both in the information services sector), Essilor (an eyeglass lens manufacturer), and Compass Group (a contract caterer), at 2.77%, 1.54%, 2.22%, 1.94%, 1.14% and 1.89% of Invesco International Growth Fund total net assets as of June 30, 2018, respectively.

Valuation. Valuation has recently been the worst-performing component of our EQV philosophy. In recent history, high-valuation (expensive) stocks meaningfully outperformed.  We remain convinced that identifying high-quality businesses at attractive and reasonable valuations remains the most sensible long-term investment strategy.

A specific example

Occasionally, we are asked to compare our holdings with specific names that we don’t own. A recent example is L’Oreal (the French cosmetics company), which was the best-performing European consumer staples company in the second quarter. Why doesn’t the Invesco International and Global Growth team own L’Oreal?

We really like the earnings and quality of the business; however, we simply feel the market is paying too high a valuation for the stock. Invesco International Growth Fund and Invesco Global Growth Fund actually bought L’Oreal in 2011 and enjoyed more than a 50% gain in the shares in the subsequent 18 months. Our reason for exiting the name was that the shares had become too expensive to justify holding. That was at a 23x price-to-earnings ratio — the shares are now trading at 29x next twelve months estimated earnings.1 In addition, L’Oreal’s price-to-earnings ratio is currently at a 125% premium to the overall market;1 that’s a relative valuation level we haven’t seen since the early 2000s.

With that example in mind, it’s worth asking: If we’re unwilling to pay such elevated valuation multiples for strong earnings and quality, then what types of opportunities attract our attention? In the last year, we have initiated positions in a couple of European consumer staples companies that we believe are attractive from a Valuation perspective, as well as an Earnings and Quality perspective.

  • Reckitt Benckiser, a leading global producer of consumer health, hygiene and home care products with strong brands including Enfamil infant formula, Mucinex, Durex and Lysol (1.64% of Invesco International Growth Fund as of June 30, 2018)
  • Philip Morris International, the leading global tobacco manufacturer that sells Marlboro cigarettes outside of the US; they also sell iQOS, the world’s most successful lower-harm, heated tobacco product in the market (1.12% of Invesco International Growth Fund as of June 30, 2018)

We believe these companies have similarly attractive earnings and quality outlooks, but most notably, they are trading at a 40% price-to-earnings discount to L’Oreal.1

Key takeaway

The first half of 2018 has proven to be a challenging environment for our EQV investment style, but we believe that chasing performance with limited regard for valuation is not a reliable strategy over the long term. The strong earnings upgrade cycle seen since late 2016 now appears to be fading. We believe that by adhering to our disciplined, well-balanced EQV philosophy, we have built a portfolio that should be well-positioned to potentially benefit when the market eventually refocuses on fundamentals and valuation.

See where the Invesco International and Global Growth team views opportunities around the world.

Read more blogs from the Invesco International and Global Growth team.

1 Source: Bloomberg L.P, data as of June 30, 2018

Important information

Blog header image: AVN Photo Lab/Shutterstock.com

Invesco International Growth Fund Risks:

Derivatives may be more volatile and less liquid than traditional investments and are subject to market, interest rate, credit, leverage, counterparty and management risks. An investment in a derivative could lose more than the cash amount invested.

The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.

Growth stocks tend to be more sensitive to changes in their earnings and can be more volatile.

Stocks of medium-sized companies tend to be more vulnerable to adverse developments, may be more volatile, and may be illiquid or restricted as to resale.

The Fund is subject to certain other risks. Please see the current prospectus for more information regarding the risks associated with an investment in the Fund.

Mark McDonnell is a Senior Equities Analyst with the Invesco International and Global Growth team, focusing on large- and mid-cap equities in Europe, Canada, the Middle East and Africa.

Mr. McDonnell joined Invesco in 2003 as a quantitative analyst on the International and Global Growth team and was promoted to equities analyst in 2010. He assumed his current role in 2014. Mr. McDonnell entered the investment management industry in 2002 as a summer intern with the hedge fund Zimmer Lucas Partners LLC.

Mr. McDonnell earned a BBA in finance from The University of Texas. He is a Chartered Financial Analyst® (CFA) charterholder.

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