Found: The ultimate contrarian investment

Found: The ultimate contrarian investment. The price is only 37 times earnings.

Possibly the most conventional bit of wisdom in investing, borne out by countless studies, is that generally, over long periods of time, shares on low price/earnings (PE) ratios outperform shares on high PE ratios. The PE, simply the price of a share divided by a year's earnings per share, is a ubiquitous financial statistic.

It's a proxy for value. Earnings are the profits left over for shareholders once a company's expenses have been paid. If you pay a high price for those profits, your return will be lower. Invert the PE, divide earnings by price, and you express it as a yield, a crude measure of the return on your investment.

A PE of 5 is equivalent to an earnings yield of 20%, a PE of 10 is an earnings yield of 10%, a PE of 20 is an earnings yield of 5%. Depending on the alternative homes for our savings, most of us require a certain minimum return from our shares and so we fixate on PEs. We may deem companies trading on PEs below 10 and yielding 10% "cheap" or companies trading on PEs above 20 and yielding 5% "expensive".

Breaking the rules

The PE has the virtue of simplicity, but it doesn't tell us much about value because profit does not stay the same. It depends on factors that are difficult to assess, some say unknowable. It depends on what happens in the future, and whether the company is well poised to benefit.

For this reason, we sometimes break our rules of thumb. If we are very despondent about the prospects of a company we might not buy it, however low the PE, because our returns will shrink. If we are excited about it, we might raise our PE limit because our returns will grow. These would be exceptional cases that prove the rule that, generally, low PEs are good and high PEs are bad.

While I may own shares on high valuations, I'd be concerned if the average PE of my portfolio was over, say, 20.

The number 37

That's why I returned from the Fundsmith Emerging Equity Trust annual general meeting with the number 37 imprinted in my mind, where it remains. The investment manager of the trust, Fundsmith, is run by Terry Smith, and in a presentation attended by perhaps a hundred shareholders he said, without even raising his hawkish eyebrows, that the average PE ratio, for the 50 shares in the trust, is 36.7. A PE of 37 is an earnings yield of 2.7%.

If we take the figure at face value, I'd be better off paying down my mortgage than buying shares in Fundsmith Emerging Equity.

I admire Smith for sharing this statistic, and others. It's only by understanding these figures that we can really understand what we are investing in. It also makes the investment trust he runs look even more expensive than the value yardstick he favours does.

Smith literally wrote the book on cooking the books (it was called Accounting for Growth), so he's sceptical about accounting profit. He prefers to base his calculations on cash flows. The cash flow equivalent of earnings is free cash flow, and the cash flow equivalent of the earnings yield is the free cash flow yield.

The companies in the trust earn copious amounts of free cash flow - more than they do in earnings, which is unusual, so the free cash flow yield is higher than the earnings yield. It's 3.9%.

It must be all-but inconceivable to Fundsmith that the companies the trust has invested in won't grow.

Fantastically profitable

Smith throws in another statistic. On average the 50 companies are fantastically profitable. They earn a return on capital of 53%. He quotes Charlie Munger, the slightly less famous half of the duo that runs Berkshire Hathaway, probably the most successful investment vehicle of all time:

"Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over forty years and you hold it for that forty years, you're not going to make much different than a six percent return - even if you originally buy it at a huge discount.

"Conversely, if a business earns 18% on capital over twenty or thirty years, even if you pay an expensive looking price, you'll end up with one hell of a result."

It's very easy to demonstrate in a spreadsheet that compounding, a successful business reinvesting profit at high rates of return, trumps value, the price you paid to invest in that business, many, many times over.

But there's a complication. A lot can happen in 20, 30 or 40 years. A company earning a 53% return on capital today is most unlikely to be that profitable after decades have gone by.

Generally the return on capital of highly profitable firms falls as other companies figure out how to compete for those profits. The return on capital of struggling companies improves as competitors fall away. Studies show that generally profitability asymptotes towards the mean, which means profitability reverts towards the average.

Fundsmith must be very confident that the companies it picks will be more than usually resilient to this mechanism.

Confident investments

That confidence comes from the characteristics of the firms Fundsmith invests in. These firms target consumers, who are unsophisticated buyers of products. While businesses have departments dedicated to low-cost procurement, individuals are governed by habit and emotion.

Fundsmith invests in companies selling relatively cheap everyday products, food and household goods, that people buy through thick and thin. It invests in companies with operations in countries with fast-growing middle classes, where demand for these goods is increasing fastest, like India. It's more cautious where there is potential for instability, like Brazil or China, or, for that matter, about businesses prone to technological disruption.

It's more confident where it can identify competitive advantages, for example brands lodged in consumers' minds, patents that prohibit copycats, distribution networks that would be improbably expensive for competitors to replicate or installed bases of machinery that lock customers into service and maintenance contracts.

Very generally, shares on high PEs make bad investments, and - generally speaking - highly profitable companies become less profitable. These are two fundamental truths in investing, yet Fundsmith Emerging Equity is going against both.

Despite the fact that the shares it owns have eye-watering valuations by conventional measures, Fundsmith reckons they are undervalued because its analysts, four, each monitoring about 40 companies, have found exceptions. Their high levels of profitability will be sustained.

If that's true then, despite their apparent popularity, the investments in Fundsmith Emerging Equity are perhaps the ultimate contrarian stocks.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Contact Richard Beddard by email: richard@beddard.net or on Twitter: @RichardBeddard