Following a good year globally for the high-quality stocks that we favour, valuations in certain parts of the market have started to look stretched. However, we believe some investors have been far too quick to dismiss whole categories of the market as expensive, ignoring the strong competitive advantages and positive long-term growth profiles of high-quality businesses within these sectors.
This is particularly the case with technology companies, where the explosive gains of the so called ‘FANG' stocks, Facebook, Amazon, Netflix and Google (now Alphabet), have been well documented. Over the past 12 months, we have slightly reduced our exposure to some technology names where valuations have looked pricey.
But we believe other technology stocks are by no means expensive and could even perform better in 2018 than they did in 2017. The simple fact is that if we thought a stock was expensive in respect to its long-term growth prospects we would not hold it.The key is to be as stock specific as possible, focusing on the fundamentals of individual names rather than sectors as a whole.
Microsoft is a good example of why stocks need to be judged on their own merits. Contrary to what might be expected, it is not on the very high multiples many people associate with technology giants. At the time of writing, on a price/earnings basis Microsoft was trading on around 30 times, which makes it neither cheap nor expensive (1). Moreover, as the company achieves traction in its cloud business, Azure, it is one of the stocks that might well perform more strongly in 2018.
When assessing competitive advantages, we look for companies protected by economic moats.
So, it is positive to see that long-term users of Microsoft's desktop software and servers are sticking with the company they are familiar with when looking for a cloud-computing solution. For the past several quarters, Azure has been growing much faster than Amazon Web Services, the leader in the cloud infrastructure market (2). The trust many users have in the Microsoft brand has created an economic moat reinforcing the business's competitive advantage.
Over the past 12 months, we have slightly reduced our exposure to some technology names where valuations have looked pricey.
But, we believe other technology stocks are by no means expensive and could even perform better in 2018 than they did in 2017.
Regulatory threat
The biggest risk to the growth of the likes of Amazon, Facebook and, possibly, Microsoft over the next 12 months is not their valuations, but instead a growing political and regulatory threat.
Governments worldwide are searching for ways to more heavily tax and control the tech giants.The British chancellor Philip Hammond's plans, announced in the November Budget, to consider taxing technology companies based on their sales in the UK could be a harbinger of things to come. Calls for tighter regulation have amplified since the recognition that Russian interference in Facebook and Google may have influenced the US election result in 2016.
Regulatory risk, not just in the UK but globally, is why Alphabet, on a P/E of 36 times at the times of writing,1 is in our view cheap. The threat of tighter regulation in the tech space is a factor we will be keeping a close eye on in 2018.
Emerging opportunities
We will also be watching developments in India, which is a market that we are very bullish on in the long term. India's economic growth slowed in the past year after November 2016's bank note demonetisation drive stifled activity in cash-dependent sectors. Similarly, July's introduction of a Goods and Services Tax (GST) caused disruption as businesses initially struggled to adapt.
Now these events are in the rear-view mirror, we expect a re-acceleration of growth, fuelled in part by the introduction of the GST, which has cut red tape and will increase tax revenues. Whether the economic pick-up results in significant share price gains for Indian companies in 2018 has yet to be seen, but it is positive longer term.
Given that our investment approach is bottom up, our decisions tend not to be too driven by macro factors. But India looks like a macro opportunity that it would be unwise to ignore. Likewise, the hugely significant demographic shifts taking place globally also present an opportunity.
In much of the world - India being one of the few exceptions - populations are ageing fast, ensuring that the outlook is positive for healthcare stocks. Any companies that help take costs out of the healthcare system look particularly well placed to benefit. In 2015, the overall share of the US economy devoted to healthcare spending was a staggering 17.8% (3).
We are bullish on India where we expect to see a re-acceleration of growth, fuelled in part by the introduction of the Goods and Services Tax which has cut red tape and will increase tax revenues.
Committed to quality
Our high-conviction approach to investing focuses on identifying the world's best quality companies with sustainable competitive advantages that deliver persistent, reliable and repeatable results. I make no claim to be able to predict whether quality stocks overall will have a good 2018 on global markets.
The strong performance of high-quality growth over the past year was partly a catch-up effect. Right after the November 2016 US election, high-quality growth did poorly relative to small cap and value as investors sought out cheap, economically-sensitive names. But as hopes fizzled that Donald Trump could enact reflationary policies that would substantially boost US economic growth, the growth style of investing returned to the fore.
Such shifts in sentiment happen frequently and I have no idea whether quality will outperform value again in 2018. However, I am confident that the high-quality global companies we favour are best placed to prosper on a multi-year view.
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