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Investors should look for ‘unreasonable’ investments, says Kames Capital

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Investors need to step away from stocks which purport to offer ‘growth at a reasonable price’ and instead focus on opportunities which others find ‘unreasonable’, Kames Capital’s Pauline McPherson (pictured) says.

McPherson, who co-manages the Kames Global Equity Fund, argues that while it is understandably difficult to go against the consensus, investors need to continually challenge their own views, in order to avoid the common tendency to follow the herd without independently assessing companies.
 
“Throughout history, the world’s greatest thinkers have warned us against becoming too comfortable with our ideas,” she says. “Sticking with the consensus approach and seeking ‘reasonable’ investments is actually very limiting, leading to compromise, low conviction and a comfortable middle ground that rarely leads to outperformance.”
 
Indeed, such an approach can lead investors to ignore some of the best opportunities in markets, McPherson says, in particular unloved stocks which are out of favour but remain sound businesses. It is also too easy to disregard stocks labelled ‘expensive’ following an extended period of gains off the back of positive news flow.
 
“With intimate knowledge of companies and their business models, it is possible to identify opportunities that appear cheap and unpalatable to most investors, or to identify expensive stocks that will generate supernormal growth, perhaps because a new industry is being created, a new technology is being developed, or a new business model appears that is capturing something new,” she says.
 
Three examples of ‘unreasonable’ investments the team holds in its global equity portfolio are:
 
Unreasonable value – Investors typically dislike Japanese insurance companies because the Japanese bond yield is so low that the returns they make on their investments are lower than the promises they give to their policy holders. Those policies can be as long as 15 to 20 years, so the market tends to price a company like Dai-ichi Life as though it will make 15 to 20 years of losses.
 
Our view is that the company is taking mitigating action, has overseas earnings that are becoming more valuable as the yen weakens, and has a core non-life business that will generate attractive returns. Since purchase the stock is up a considerable amount, and we think it can rise even more substantially. In this instance, we were willing to look at something that other investors wouldn’t touch, and year-to-date this is our most successful holding in our global equity strategy.
 
Unreasonable recovery – When Lufthansa began encouraging passengers to book through their own system, investors became concerned about Amadeus, the Spanish IT services provider that holds a dominant position in processing airline bookings. Amadeus’ stock fell 20-25 per cent in two weeks. We know the company’s business model well, and believe that Lufthansa is making a bold bet while holding a weak hand. The stock has already recovered since the time of purchase. It was not a cheap stock, but we were comfortable being bold when others were fearful.
 
Unreasonable growth – Mobileye develops technology for semi-autonomous and autonomous driving. When we purchased this stock, it was trading on 140 times earnings. However, the rate of growth of the company’s revenues (50 per cent based on recent results) and significant operational leverage within the business meant that continued sales growth would feed straight through to profits.
 
Mobileye has been adopted by almost every automotive manufacturer in the world. We believe its penetration rate will be similar to previous automotive equipment, such as airbags and disc brakes. Mobileye is a clear example of a type of discomfort very different from buying an exceptionally cheap or unloved stock. Instead, it is the discomfort of mustering the courage to buy an unreasonably expensive stock, and the conviction, backed by analysis, that it will get even more expensive.
 

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