‘The stock market is filled with individuals who know the price of everything, but the value of nothing’ – The final instalment.

At the beginning of May 2020, we wrote our first note with the title above, starting our ‘experiment’ to see whether ‘value’ might outperform ‘growth’ over the subsequent five years, and before you know it – here we are! As a reminder, we chose Rentokil Initial as our growth proxy and Imperial Brands as our value proxy and, as regular readers will know, we have updated our analysis every year since 2020 and now it is time for the final verdict.

The table below highlights some of the key financial metrics for Rentokil over the five years from 2019 to 2024. We won’t review all the detail here, as we have covered it in previous annual updates, but suffice to say, the combination of reasonable levels of organic growth and an active acquisition strategy which included the ‘transformational’ acquisition of US business Terminix in 2022, has meant Rentokil has grown very strongly. Turnover and operating profit have more than doubled in the period, whilst earnings and dividends (impacted by a significant increase in the share count) have grown by less but still healthy amounts.

In contrast to the excitement at Rentokil, Imperial Brands have arguably had a much more mundane five years of limited growth, as the table below shows very clearly (note that Imperial’s year end is September rather than December as in Rentokil’s case). A relatively new management team have spent the period strengthening the core business, reducing debt, and then trying to kick start a degree of organic growth. Consequently, turnover and operating profit have grown only marginally across the period and earnings (helped by a reduction in share count through share buybacks) have grown a little more but still fairly modestly. In addition, management took the painful decision to cut the dividend early in their tenure and as such it has fallen significantly over this time horizon.

Given such an apparent divergence in operational performance, it would be perfectly reasonable to have expected a similar divergence in share price performance as well. Indeed, as the chart below highlights, that is exactly what has happened – only in the completely opposite direction! The relatively mundane operational performance of Imperial Brands has been rewarded with a +185.8% total investment return, including dividends, over the five-year period (the white line), whereas the optically exciting operational performance of Rentokil has delivered a total investment return of -18.7% (the blue line). The net result is +204.5% outperformance for Imperial Brands!

What could explain this outcome? Quite simply, perceptions change. Regular readers will understand the importance we place on starting valuations as a key driver of the ultimate return you make on investments. Changes in valuation multiples, typically driven by changes in investor perceptions, are often far more material to your ultimate investment return than the operational performance of the underlying business and this, in our view, is a perfect example of that dynamic in action.

At the start of our journey, Rentokil had already had several excellent years of operational and share price performance and was very much a ‘favoured’ company for many investors. Consequently, the shares were valued at c. 35x Price/ Earnings (P/E) ratio. More recently, as operational performance has come up short of investor expectations, particularly following difficulties in North America post the Terminix acquisition, sentiment towards the company has soured materially. This has been reflected in a ‘derating’ of the shares to a P/E ratio approaching c. 16x and this has been key in the relatively poor share price performance over the period.

In complete contrast, at the start of our journey Imperial Brands was deeply out of favour with general investors. Several years of disappointing performance, alongside the tobacco sector being considered ‘uninvestable’ by many, left the shares trading on a very depressed P/E ratio of just 6x. After five years of steady, if unspectacular, operational performance, the P/E ratio has risen to c. 10x, and this has been key to the solid investment return delivered.

Our fund has benefited handsomely from investing in Imperial Brands over the last five years and we have, in the past few weeks, made the decision to sell the last of our holding. Whilst a valuation of 10x P/E is hardly expensive, and there may yet be further upside to come, we are cognisant of the ‘rehabilitation’ that has already been achieved and, as is typically our way, we are keen to recycle our capital into new opportunities that are potentially at a much earlier stage in this process.

Ironically, Rentokil may, in the not too distant future, represent one such opportunity. Following the recent operational challenges and the souring of investor perception, the long-standing Chief Executive has announced plans to retire and a new team, no doubt fresh with innovative ideas, may well put the business on a better trajectory in due course. For us, it is not yet time to invest, as we think there are additional building blocks still to be put in place, but it may come soon – such is the lifecycle of investing opportunity in markets prone to persistent swings between euphoria and depression.

Clearly, these are relatively extreme examples of changes in valuation multiple in action, and it has certainly not been a universal phenomenon in the ‘value’ verses ‘growth’ debate over the past five years. Nevertheless, we hope it provides a useful illustration of the importance and power of such moves and a reminder that, when it comes to the psychology of investing, things are rarely ever as ‘good’ or as ‘bad’ as they appear through the fickle eyes of ‘Mr. Market’ – and that frequently presents significant opportunities for active investors willing and able to capitalise on them.