For the investment industry, there is a sense of déjà vu. After a terrible 2022, the debate has reignited between not only active and passive management, but also about what distinguishes value investing from ‘quality’ investing. Most crucially, the question asked is how these principles can be applied to Dubai in its capital and asset markets.
Value investing, in the hands of most practitioners, has morphed into a simplistic approach of investing in stocks with low valuations. Looking at history, we know this to be fallacious. If we look at valuations of well-known global stocks in 1973 (when inflation started to skyrocket after the first oil shock), you would have paid 281 times earnings for L’Oreal, 126 times for Colgate or 63 times for Coca Cola. In all of these cases, you would have achieved a return in excess of 7 per cent annually over the next 30 years, and beaten the index.
Curiously, none of these companies were considered ‘disruptors’ or high-growth companies even then. In none of the above cases would the companies have been classified as ‘cheap’, and yet investors would have outperformed any passive ETF investment model. Why? The answer lies in the fact that all of these companies had returns on capital that were increasing, and were companies that returned capital to their shareholders on a regular basis.
Cushioned against market cycles
Two important factors stand out here: first, in bull markets, where a rising tide lifts all boats, highly leveraged business models will inevitably outperform the more ‘boring’ counterparts. The temptation here is to switch to the ‘disruptors’, or business models that emphasize change over return on capital employed. The second is, when sentiments change (as they did on 2022), high quality and disciplined companies have nothing to recover from.
When we look at Dubai, and more specifically the recent spate of IPOs, the return on capital invested - as well as dividends - have been the key variables highlighted, but a look under the surface reveals a strong cash generation engine that in insulated from the cyclicality that affects most other sectors. More critically, the return on capital invested for Salik, Dewa, Empower, Tecom and Taaleem exceeds the not only the rising cost of capital, but, more importantly, is inoculated from traditional concerns regarding oil prices variability.
Best placed for a decade’s worth of growth
The recent D33 goals announced by Dubai underpin the growth paradigm of the city for the next decade. We know that growth is a strong component of valuation, which is why we have seen international fund flows increase dramatically. With increasing information dissemination regarding the performance of local companies, the competition for investment allocation has intensified. In this sense, the business case model for the retail investor is not an either/or approach. but a diversification to companies that will grow sustainably over the next decade.
There will be many more disruptors that will undoubtedly enter the fray, including some from the UAE. And there will even be a case to be made to buy into some companies whose valuations have fallen significantly. However, the fact remains that over long periods (say, over a decade), where the future is virtually unknowable, the process of constructing investment portfolios has to account for business models that generate returns on capital on a sustainable basis. Rather than your friendly neighborhood startup that relies on capital injections on a periodic basis.
Dubai has staked its claim to achieving the status of global financial center within a decade. This reach for growth will reflect in company valuations, and hence capital market activity and outperformance are a natural outcome of this. For individuals and institutional investors alike, it would be unwise to bet against it.