Scottish Investment Trust : Why we value valuations

At The Scottish, we're rarely accused of being fashionable. We seek opportunity in the unloved and underappreciated. But stockmarkets are fickle in their affections: 'ugly ducklings' can go on to become beautiful swans while the market's passionate affair with the most exciting investments often unwinds. Something of the sort appears to be underway at present - which could make our portfolio look uncharacteristically chic.

Markets are driven by sentiment and emotion, and they frequently lurch too far in one direction or the other. That's why we pay attention to valuations - quantitative assessments of a company's fundamental current and projected worth.

Of course, valuation metrics are imperfect tools. Any projection of a company's future value rests on assumptions, estimates and best guesses. What valuations do provide are anchor points that give a credible approximation as to the real worth of a company. That discipline can help investors avoid being swept along by the tides of market sentiment.

We put valuation at the heart of our investment process. For contrarians like us, the key is judging whether the valuation implied by current share price is realistic before judging how we view the potential for change. This approach requires patience, but we believe that it provides a favourable long-term balance of risk and reward.

While valuations are an important part of our approach, we never buy a stock just because it appeared 'cheap'. The quantitative appeal of the valuation must be mirrored by qualitative attractions such as strong leadership or enduring competitive advantage. Crucially, there must be clear catalysts for improvement; we want the company to positively surprise.

Fundamentals out of favour

For a prolonged period many investors have been apparently indifferent to valuations, and this has shaped the market's direction. The main effect has been a strong emphasis on momentum. In other words, previous 'winners' have kept winning, regardless of how stretched valuations have become.

There are several reasons for the perceived lack of interest in fundamental valuations.

One is the rise of passive investing, which drives momentum by automatically buying more of the stocks that have already performed well, further driving up valuations.

Another is the growing proportion of inexperienced retail investors. Many people bought shares for the first time during the pandemic. These investors often have little understanding of fundamental valuations and are sometimes motivated by short-term gains ahead of long-term returns. A classic example was GameStop's incredible performance earlier this year, when huge numbers of retail investors bought the company's shares in complete disregard of its fundamental value, or lack of it.

A third factor is the extraordinary monetary policy that has persisted since the 2008 financial crisis. With interest rates and bond yields held so low, investors have required ever more speculative investments to earn a return. This has driven the market valuations of certain sectors to dizzying heights; some technology companies are obvious examples here. As central banks have maintained interest rates at historically low levels to combat the economic effects of Covid, they have inadvertently sustained momentum investments. The corollary is that any normalisation of monetary policy could reverse this momentum.

Together, these factors have led to an extreme divergence in market valuations between the most and least expensive stocks. Historically this has proved unsustainable.

The opportunity ahead

As the recovery from the pandemic shifts us from a period of low economic growth and inflation to one of higher growth and rising prices, the tide seems to be turning. For the year to date, many lowly valued investments have outperformed the stockmarket's previous winners.

For those like us who keep a sharp eye on fundamental valuations, this is not a surprise. We have positioned our portfolio to capitalise on such a shift. Should current trends persist, our attractively valued holdings will be back in vogue.