Valuations and top-down asset allocations are far too imprecise and are not particularly helpful to investors, according to FE Alpha Manager Nick Train. 
Train, who oversees both the five FE Crown-rated LF Lindsell Train UK Equity fund and Finsbury Growth & Income Trust, is well known for his quality growth, buy-and-hold, bottom-up philosophy.
“Most attempts at valuing a stock market asset result in an illusory sense of exactitude. Valuation is an unbelievably inaccurate science,” said the veteran investor.
“I think that it barely deserves the term ‘science’ – it is just because people use numbers they think that it must give it some kind of scientific credibility.
“But, actually, the assumptions behind valuing anything are so dependent on massive uncertainties that valuation is not useless but it is not nearly as useful as people think.”
Performance of fund vs sector and benchmark since launch
Source: FE Analytics
There is, he countered, a theoretically correct value for everything, it is just that it is very difficult to establish what that is.
He said that for some companies, this can be much higher than the stock market, and indeed investors, give them credit for.
Valuations have been a big talking point over the past 18 months as investors have largely agreed that markets – which hit multiple record valuations several times last year – have become more expensive.
But Train said that certain exceptional businesses, such as the quality growth names within his portfolio, deserve to be very highly valued.
“The way we think about valuation is that these very rare, exceptional companies probably could easily justify price-to-earnings [P/E] ratios in the 30x or the 40x,” he said.
“There is quite a lot of theory and anecdote that supports that proposition, but let’s just say that as a rough generalisation we work on the assumption that truly exceptional businesses could easily be worth 40x earnings.
“To the extent that they are not for much of the time – in fact they very rarely do get valued at those sort of apparently high levels – that from our perspective is an opportunity and a ‘value opportunity’.”
Where it can provide insight for investors and fund managers however is when a company is acquired by another firm.
“That provides really valuable information – not exact – but it provides information about what a commercial entity thinks something is worth rather than what a stockbroker, analyst or hedge fund manager might think something is worth,” he said.
Using the example of Cadbury a few years ago, which he previously owned, Train said he had for around 10 years been championing that the company was undervalued despite its high multiple.
“Then Kraft came and made a bid for it 70 per cent above where it was trading and we could say we were right. It was materially undervalued and they [the market] didn’t understand how much it was worth,” he said.
As such, when he has – very rarely – sold a company from the LF Lindsell Train UK Equity fund or the Finsbury Growth & Income Trust, it has typically been due to problems with the franchise or where he has misjudged the quality of the business.
“That obviously has implications for the warranted value but it was not because it was overvalued,” he said.
“I am not saying it is not inconceivable. It is conceivable that even our beloved Diageo, if it were trading on 50x earnings, maybe we would say ‘Well, however much we love this, that is overvalued’. But in practice it hasn’t really happened.”
A current example is Pearson, which he said has been a “problematic investment” for the fund.
Over the past five years the share price has fallen by 13.09 per cent and is 26.6 per cent lower than its peak in April 2015. Over the past 12 months the shares have bounced back however and are up 54.25 per cent.
Performance of stock over 5yrs
Source: FE Analytics
Train said: “I am not crowing because we have owned it a long time and it has not been a good investment, but it is not up 50 per cent because people decided it has got too cheap.
“It is up 50 per cent because it has got tentative preliminary signs that its strategy of moving to digital is working. It is that that might make it cheap not the valuation.
“The narrative or the story surrounding a company for us is more important than the so-called valuation.”
The other area the manager pays little attention to is geopolitics, macroeconomics and any other external, top-down factors – at least from the sell-side.
He noted that the Brexit vote in 2016 was a good reminder as to why he, along with colleague and fellow FE Alpha Manager Michael Lindsell, spend little time worrying about such events.
“Rightly or wrongly it is a long time since Mike and I tried to work out what macro politics means for our portfolio holdings and I have to say I really think that the experience of 2016 reinforces that proposition,” he said.
“Like everybody else we would never have got the outcome of the vote right or the reaction of capital markets to the vote.”
Indeed, the FTSE All Share index initially plummeted 7.01 per cent as sterling weakened and investors feared the worst. However, since then, the UK market has recovered and the index has since generated a total return of 30.07 per cent, as the below chart shows.
Performance of index since EU referendum
Source: FE Analytics
Train said: “We were as utterly bewildered as anybody else and I think this stuff is ineffable – it is literally unknowable.
“People say to me what’s your view on a hard Brexit and I say ‘I’ll give you my view if you tell me how much of a hard Brexit is already reflected in prices’.
“Of course, no one can say because it is not knowable but it must be to a degree reflected because everybody is talking about it. I just find it not helpful really.”
However, he does appreciate the opportunities that can come about from these events, noting that curing the Brexit vote some of his preferred holdings were caught in the cross-fire.
One such company in LF Lindsell Train UK Equity is Hargreaves Lansdown – the fourth-largest position in the fund with an 8.4 per cent weighting – which fell 23.97 per cent.
“I guess that was hit by Brexit and in hindsight that was a good opportunity to invest in what has carried on being a fantastic growth story,” Train said.
“We added to the holding but that wasn’t predicated on a particular view about Brexit it was just stuff going on in the market that happened to be about Brexit created an opportunity to buy something more that we like.”