Often perceived as old-fashioned in comparison to growth or momentum, value investing is the art of buying stocks that trade at a significant discount to intrinsic value. Investors can gain exposure to value strategies through select funds, many of which have delivered long-term outperformance, offer diversification from the more typical UK portfolio as well as protection against market falls.
Value investing explained
A proven, long-term approach, value investing focuses on exploiting swings in stock market sentiment. The focus is on identifying companies which are valued at less than their true worth and then waiting for a correction. Value investing suits contrarian investors with patience, since it is not always in favour and does not always outperform over shorter time periods. Yet when legendary proponents of the art include the dean of value investing, Benjamin Graham, as well as Warren Buffett and Seth Klarman, only the foolhardy would dismiss value as a strategy. Put simply, Buffett likes to buys quality merchandise when it is marked down, whether it be socks or stocks. A valuable lesson taught to Buffett by mentor Ben Graham is that price is what you pay; value is what you get.
Value investing had been out of favour for a decade – ‘quality-value’ growth or momentum strategies have held sway – yet value shares outperformed in 2016, rallying as the market’s prior focus on higher quality/lower volatility stocks, and their associated
strong price performance, left not only these stocks expensive, but the short-side of this trade exposed to increasingly cheap stocks.
However, value’s outperformance last year has to be put in the context of an unusually weak decade. As Dan Brocklebank, Director, Orbis Investments, recently explained: ‘One good year certainly doesn’t mean value’s time is up. Rotating out of value shares or avoiding them for fear the rebound has played out could prove costly for long-term investors.’
Key value metrics
Ways to determine if a stock is trading below its intrinsic value include a low price-to-earnings (PE) ratio. Value hunters also look for a low price to book ratio - stocks trading at a discount to net assets or ‘book value’ might pop up on a value seekers radar.
Another key metric is the enterprise multiple or EV/EBITDA ratio, which unlike the P/E ratio, takes debt into account and as such, is a better indicator than market cap for unearthing takeover candidates. Another important metric is the discounted cash flow analysis, which calculates whether a stock is attractive or not by using future free cash projections and discounting them to arrive at a present value, which is then used evaluate the potential for investment.
Value investing seeks to exploit the irrational behaviour of emotional investors, whose fear and greed remain ever present and lead them to make investment decisions based on perception and emotion rather than reality. The most common reason that a stock trades at a discount to its intrinsic worth is short term profit disappointment, typically triggering a share price slump.
The value investor recognises that most businesses are long term in nature and the real effect of short term profit falls on the long-term value of a business is often small. They also recognise that on average most company profits are mean reverting over time, so that over the longer term, savage profit falls are often reversed.
Vehicles of value
Therefore, value stocks (sometimes known as recovery stocks) tend to outperform because the investor expectation reflected in their share prices is less demanding, and thereby easier to beat, sometimes by a significant margin. The flipside is the business (and share price) continues to underperform, leaving the contrarian investor caught in a ‘value trap’.
Investors can access value opportunities through the acumen of professional fund managers including bottom-up stockpicker Alex Wright, manager of two contrarian funds at Fidelity: Fidelity Special Situations (GB0003875100) and Fidelity Special Values (FSV). (JC)
Paul Mumford, Cavendish Asset Management
Paul Mumford, fund manager at Cavendish Asset Management, says he feels quite positive about markets moving forward. ‘There are so many interesting opportunities and cheap stocks. There are more stocks I want to buy now than at any time in a number of years.
‘Investors have shunned domestic stocks, in particular, since the fall in sterling. You are getting some very good value there.
‘I think sterling will recover, although it might take five years to do it. I believe once negotiations are complete and we are detached from Europe, people will see the UK as a decent place,’ adds Mumford.
‘Debenhams (DEB), Moss Bros (MOSB), Bonmarche (BON), Laura Ashley (ALY) – these are all giving investors a decent return and have reasonable balance sheets. Profit margins are under pressure but share prices have already fallen.’
Mumford has pedigree in making contrarian calls, as laid out in his newly-published book The Stock Picker. He likes to explore depressed parts of the market and has been lucky buying just before share prices recover.
‘I was buying housebuilders before the sector recovered; I was buying oil and gas stocks last year and people thought I was wrong. People said these areas looked gloomy, but the market had already anticipated that.
Raise your glass
Another area that excites Mumford is pub companies. ‘You’ve had some pretty good figures from them recently; you’re getting some pretty darned good dividend yields; and only have to pay single figure multiples to buy the stock. No-one seems to like them at the moment as everyone is concentrating on exporters. I think the sector will recover in due course; the difficulty is the timing.’
He also think the oil and gas sector has tremendous potential. ‘I have mainly North Sea-related stocks. Ithaca Energy (IAE:AIM) will be paying down debt quite sharply. Hurricane Energy (HUR:AIM) is pure exploration and has enjoyed significant success. We participated in a placing for Northern Petroleum (NOP:AIM) – I believe that could be a three to four bagger in a fairly short space of time.’
Some of these stocks appear in several of Cavendish’s funds. Anyone seeking ideas from a value perspective may be best served looking at Cavendish Opportunities Fund C Acc (GB00B9F9Z985) from its product range. This fund aims to invest in equities falling mainly under the categories of smaller companies which offer long-term growth, companies which offer recovery prospects and companies in sectors of the market which are perceived to be unduly depressed. (DC)
Nitin Bajaj, Fidelity Asian Values
Softly spoken with a very straight-forward value investment philosophy, it comes as no surprise that Nitin Bajaj is a big Warren Buffett fan. ‘We look for good quality companies being run by good management,’ simply states the manager of the Fidelity Asian Values (FAS) investment trust.
His preference is smaller and medium-sized enterprises (SMEs) – the average target market cap of the fund is $1bn. This is because they tend to get overlooked by most other investors, allowing he and his team to gain an edge. Companies with low debt and diversified revenue streams capable of putting up 50%-plus investment returns on a three-year horizon are typical boxes to tick.
Asia, encompassing anywhere east of Istanbul except Japan, has emerged as the world’s fastest growing region and features an estimated 15,000-plus listed companies.
It’s a vast pool in which to fish for mis-priced companies but there is no magic formula and Bajaj largely overlooks geopolitical and macroeconomic data in favour of investment analysis heavy lifting. The fund manager demands rigorous fundamental analysis, with a bottom-up stock selection approach. ‘We simply have more analysts on the ground than anyone else,’ he says.
The SME focus is relatively new, Bajaj’s decision since taking over the trust’s management in April 2015. But while potential investment returns may be more promising from SMEs that also tips the risk scales some, and means few will be familiar with its main holdings. The two biggest, Power Grid Corp of India (PGRD:NS) (3.93% of the trust) and Tisco Financial (TISCO:BK) of Thailand (3.08%) are long-run favourites of Bajaj, both added to the trust’s portfolio since he joined. Singapore’s RHT Health Trust (RHTH:SI), the sixth largest stake at 2.16%, is another Bajaj has liked for some time.
But this change of tack also skews the investment performance statistics, which have been consistently strong versus its MSCI Asia Pacific ex-Japan benchmark. The trust has outperformed in almost every year of the past 10, according to Morningstar data, delivering a 9.38% average annual share price return against the benchmark’s 2.87%, although most of that is a hat tip to previous manager John Lo. But encouragingly, that trend has continued more recently, ahead of its benchmark on a one, three, six and 12-month basis, based on Trustnet stats. (SF)
Manager seeks downside protection
Fidelity Special Values (FSV) 228p
Estimated NAV: 234.27p
5-year annualised return (NAV): 18.6%
Run by star manager Alex Wright, Fidelity Special Values (FSV) is an investment trust which looks for ‘individual change stories’, stocks undervalued by the market and whose growth potential isn’t yet appreciated by other investors. Contrarian Wright looks for change in unloved areas of the market which leads to his value bias. His investment approach has two key elements; downside risk management and unrecognised growth potential. ‘We’re very much considering the downside and thinking about that first,’ says Wright, who looks for a margin of safety in his investments. This can be found in exceptionally cheap valuations or some asset that should provide a share price floor, ranging from inventory to intellectual property. Wright’s process also sees him ‘steering clear of very indebted companies where the chance of losing your money is much higher.’ As at 30 November, Fidelity Special Values’ top overweight positions included home emergency, repair and heating installation group Homeserve (HSV), defence, security and transport play Ultra Electronics (ULE) and oil major Royal Dutch Shell (RDSB). Other positions included Citigroup (C:NYSE)
and building materials firm CRH (CRH); banks and construction are two unloved sectors where Wright sees potential for positive change. (JC)
61% of the fund is in large cap stocks
Jupiter UK Special Situations (GB0004777347) 187p
5-year annualised return: 12.8%
Fund size: £1.4bn
Ongoing charge: 1.75%
Manager Ben Whitmore’s skill at identifying quality businesses which have been unfairly neglected by other investors could prove useful amid a shift away from so-called ‘expensive defensives’. Whitmore has been in charge of the fund for just over 10 years. He looks for enduring businesses which are going cheap and runs a pretty tight book of around 40 names. He uses two value based screens to identify opportunities and then analyses the individual qualities of a company. The focus is on the ability to generate cash over profit and on the ability of the balance sheet to cope with unanticipated events.
Whitmore’s investment process avoids trying to predict company earnings as well as the future direction of the stock market and interest rates. A top quartile performer, with an annualised return over five years of 12.8%, it counts among its top holdings a position in BP (BP.). The oil major was among the top performers in Shares’ list of big picks for 2016 as it benefited from a recovery in oil prices and the resolution of liabilities relating to the Deepwater Horizon rig disaster and resulting Gulf of Mexico oil spill. (TS)
This fund focuses on deep value
Schroder Recovery (GB0007893760) £204.40
5-year annualised return: 17%
Fund size: £865m
Ongoing charge: 1.66%
Running a concentrated portfolio of around 30 stocks, co-managers Kevin Murphy and Nick Kirrage marked 10 years at the helm in 2016. The fund takes a contrarian approach aiming to buy when most others are keen to sell and sell when they want to buy. They work on the assumption that outright insolvency is rare and even badly hindered companies can bounce back amid improving conditions. This focus on unloved pockets of the market is reflected in its heavy exposure to financials. The top three holdings in the fund are HSBC (HSBA), Barclays (BARC) and Royal Bank of Scotland (RBS). The fund is explicitly aimed at those with a time horizon of at least five years. Over that time-frame the performance has been impressive with a five-year annualised return of 17% according to Morningstar data. Alongside the beleaguered banks, another interesting position in the fund is Pearson (PSN). We have been negative on the academic publishing firm for some time given structural issues in its core US higher education market but accept that at a certain point this negative will be fully priced in by the market. Investors can get insights from Schroders’ wider ‘value’ team at www.thevalueperspective.co.uk. (TS)
Invests in micro caps
SVS Church House Deep Value Investments (GB00BLY2BF03) 129p
3-year annualised return: -0.24%
Fund size: £8.5m
Ongoing charge: 1.41%
Only a tiddler in overall size at just £8.5m, this fund, managed by Jeroen Bos, has the opportunity to invest in much smaller companies than many of his peers. That paid off in 2016 with an 18.8% return. Funds with billions under management are unable to funnel meaningful chunks of their portfolio into micro cap names like PV Crystalox Solar (PVCS:AIM) which delivered triple digit gains in 2016 and is the fund’s largest investment. Investment policy at the Bos Deep Value fund is based on the approach of Warren Buffett’s mentor Ben Graham who early in his career made money investing in companies that traded at or close to their liquidation value.
Other investments include the highly profitable niche asset manager Record (REC:AIM) and pawnbroker H&T Group (HAT:AIM), both of which delivered 30% plus gains in 2016. Key risks to consider at the fund include lower liquidity at the smaller end of the market which can make it difficult for a fund manager to exit positions in some circumstances, though the fund’s small size makes this less of an issue. (WC)
Disclosure: The author owns shares in PV Crystalox Solar