Is value investing back from the dead?
The basic principle of value investing is buying stocks on low valuations and waiting for them to re-rate. Warren Buffett calls it buying a dollar of earnings for 50 cents, or in the case of UK stocks buying £1 of assets for 50p. In theory this makes a lot of sense; in practice, it’s far from simple and in today’s market not a lot of stocks sell for 50p on the pound.
Value investing has been out of favour for a very long time with investors preferring to pay seemingly any price to back companies with attractive earnings growth potential.
There have been signs in recent months that this trend could reverse and put value back in favour. The big challenge for investors is to work out whether this rotation is going to be long-lasting or just short-term blips. We’ll examine the evidence in this article.
FROM OLD TO NEW
Buffett’s mentor and lecturer at Columbia Business School, Benjamin Graham, is regarded as the co-founder of value investing alongside finance professor David Dodd. Together they wrote Security Analysis, published in 1934 – in the teeth of the Great Depression, when it’s fair to say there were plenty of stocks trading on extremely low valuations.
However, value investing has changed a lot in the eight and a half decades since Security Analysis was written, with its focus on ‘book’ or asset value. Not only have new valuation methods come along, but the definition and even the usefulness of book value is being questioned.
A century ago most company’s assets would have been fixed or tangible such as land, factories and machinery; whereas today the bulk of the assets at some of the biggest companies are intangible. For example software, intellectual property, brands and patents are all intangible assets.
VALUE INVESTING BY NUMBERS
Graham and Dodd set out four criteria for value investing, creating what we would call today a screening process.
First they looked for ‘quality’ companies, defined as those with an S&P corporate credit rating of B or higher. Second they looked for a low ratio of debt to assets, preferably around one to one. Third, they looked for companies trading on less than 10 times forward earnings, and fourth they only looked for companies which were paying dividends.
The idea was to buy these stocks and hold them in the expectation that when other investors eventually ‘discovered’ them – which could be years later, given the lack of information flow compared with today – they would bid them up to their true or ‘intrinsic’ value.
This meant investors had to have a long time horizon, and the resolution to stick with their investments when they performed poorly, in the hope that they really had unearthed ‘value’ which others had missed.
This is essentially the same style of investing which Warren Buffett has used over the last 50-plus years to turn Berkshire Hathaway into one of the world’s largest holding companies. To emphasise the long-term view required, Buffett describes his holding period as ‘ideally forever’.
HAS VALUE PERFORMED?
Despite Buffett’s obvious success, being a value investor hasn’t been easy over the past decade and it’s almost never been as unfashionable as it is today. Just last month, the European Investment Trust (EUT) fired Edinburgh Partners, a respected value manager, in an attempt to close what it called the ‘persistent and wide discount’ between its share price and its net asset value (NAV).
Management of the fund was reassigned to growth investor Baillie Gifford, ‘to introduce a new investment approach targeting investment returns primarily from capital growth’.
Despite the breadth of negative sentiment towards value as a strategy, to paraphrase Mark Twain reports of its demise are greatly exaggerated.
If we compare the S&P Global Value index with the standard S&P Global index and the S&P Global Growth index, value may not have beaten growth or the market over the past 10 years but it hasn’t been a disaster either.
If we rebase all three indices to 100 starting from the end of November 2009, the growth index has gone up by 120%, the standard index has gone up 99% and the value index has gone up 80%.
According to Inigo Fraser-Jenkins, European head of quantitative strategy at research firm Alliance Bernstein, the two major reasons for the much-heralded ‘demise’ of value investing are the long period of low interest rates engineered by the world’s central banks and the rise of passive investing via exchange-traded funds.
Low interest rates were primarily a response to the global financial crisis but in the past decade the global economy has struggled to regain its old ‘cruising altitude’ so central banks have engaged in repeated bouts of monetary stimulus in the form of quantitative easing.
With growth hard to come by, investors have paid up for shares in companies which have been shown – or at least offer the potential – to grow their earnings regardless of the economic backdrop, either because they have strong pricing power for their products or services or they benefit from some other kind of ‘economic moat’.
A classic example is technology companies, which have disrupted many traditional industries thanks to their own strong ‘moats’ and through keeping much of their technological advantage to themselves in order to consolidate their market power.
‘Technology has disrupted industries in a way that may permanently destroy moats that used to exist around certain industries,’ says Fraser-Jenkins. ‘If Amazon is going to continue to destroy other parts of the retail sector, then why should we expect mean reversion to still hold? We agree that this dynamic is likely behind part of the underperformance of value.’
The rise of passive investing has meant that more money has been pumped into the stocks which have performed the best, and therefore have the biggest market weights. This process is almost self-fulfilling in that stocks which go up a lot attract yet more money. The flip side is that stocks which underperform attract little or no passive money and fall further out of favour.
POSSIBLE CATALYSTS FOR A RETURN OF VALUE
In theory, if low interest rates have favoured growth investors over the past decade, for value to outperform interest rates would first have to rise. However, given the continued lack of economic growth and in particular the low rate of inflation globally, higher interest rates seem unlikely at least in the short-to-medium term.
Still, claims that low rates and passive investing have put an end to the natural process of mean reversion which usually takes place over the economic and stock market cycle feel decidedly premature. As American investor John Templeton said, the most dangerous words in the English language are ‘It’s different this time’.
The likelihood is that the past 10 years will turn out to have been an unusually long period of outperformance by growth stocks. Central bank intervention to avert a major global depression has extended the economic cycle, while passive investing has chased growth stocks ever higher. Once more normal economic cycles return, value investing is set to take its natural place.
As AJ Bell’s investment director Russ Mould points out, recent sector performance trends not just in the UK but globally seem to raise the possibility that value is beginning to claw back some ground.
‘Value stocks are rallying while growth stocks are losing some momentum for the first time in a while. Such a move toward value would have huge implications for asset allocation and fund and stock selection if it persists.
‘Value-disciples suffered false dawns in 2016 and late 2018 so they will not be getting carried away yet, although there are tentative signs that this is not just a UK phenomenon’.
WHAT DO TODAY’S VALUE INVESTORS LOOK FOR?
Alastair Mundy, manager of Temple Bar Investment Trust (TMPL), describes his approach as ‘looking in other people’s dustbins for our buy ideas – the stuff that’s unloved, that’s been forgotten about, that people have got fed up holding in their portfolios’.
When people are at their most irrational and sell a stock based on their emotions, Mundy and his team try to take a rational approach. If the stock is cheap, they don’t buy in the expectation of a specific catalyst. ‘We’re very patient, we don’t have to make money in the next 12 months; we’ll wait for the turnaround to happen. It’s impossible to time these things to perfection.’
First he screens for major underperformers. Then he looks at the balance sheet to identify any potential structural risks.
If the stock passes these two tests the team will undertake a ‘deep dive’ into the company and conduct worst-case scenarios. If the stock still offers a large ‘margin of safety’ due to its valuation, it is subject to a peer review process and even then it might not make it into the fund.
Alex Wright, manager of investment trust Fidelity Special Values (FSV), describes his approach as looking at companies that others aren’t looking at ‘generally because there’s some short-term issue with them’.
Like Mundy, Wright and his team conduct in-depth research on companies that come on their radar to make sure that they aren’t structurally-impaired ‘value traps’ and that they have the potential to turn around.
The trust’s closed-end structure, with its ‘permanent pool of capital’, means that stocks can be held for long periods without the manager having to worry about investor inflows and outflows.
‘For a contrarian investor this is very useful,’ says Wright, as ‘cash flows can occur at the wrong time. Investors give up at the bottom or buy too high, whereas with a constant pool of capital we can hold our investments to fruition’.
Two of Wright’s holdings – media group Pearson (PSON) and defence company Ultra Electronics (ULE) – were among the top 10 most shorted stocks in the UK at the start of the year, namely ones where investors were hoping to profit from a decline in the share price. Yet Wright is sticking with his conviction that ‘while both companies have had major issues in the past, they have a more positive future ahead of them’.
WHICH STOCKS CURRENTLY FIT THE VALUE CRITERIA?
A screen of the FTSE 350 using data from SharePad shows a rogues’ gallery of cheap, ‘value’ stocks and 10-year losers.
This is very rudimentary screening process and we haven’t conducted a ‘deep dive’ into any of the stocks so some of the names which appear could well turn out to be value traps in time.
The first thing that stands out is the number of financial names on this list. Five out of the 10 cheapest stocks are either banks or other financial stocks. To us this looks as though the market thinks they are so structurally challenged that they are not worth bothering with.
If we expand the list to the bottom 10% of the FTSE 350 by price-to-earnings and price-to-book value, we get another six financial names including four of the biggest stocks in the FTSE 100: Aviva (AV.), Barclays (BARC), Lloyds (LLOY) and Royal Bank of Scotland (RBS) – all of which are trading on less than eight times this year’s earnings.
If we look at the worst performers over the past 10 years – in line with Alastair Mundy’s view that going through other people’s dustbins sometimes unearths unwanted gems – the picture looks somewhat different.
If we expand the list to the worst-performing 10% of the FTSE 350, we draught in three energy stocks – BP (BP.), Cairn Energy (CNE) and Hunting (HTG) – and another fallen support services star, G4S (GFS).
EXAMPLES OF VALUE FUNDS
Value investing means remaining patient and investing for the long-term. It also requires an in-depth knowledge of the intrinsic value of companies beyond the simple screens which we have shown.
Quite when value will rear its head and depose growth investing is impossible to tell, but there are early signs that the 10-year bull market in growth stocks is beginning to tire. One thing we are sure of is that value investing isn’t dead, and the economic cycle, while it has undoubtedly been extended by cheap money, isn’t ‘different this time’.
For investors who want to follow the value approach but don’t have the time to do their own research, there are numerous value funds in the market including the aforementioned Temple Bar and Fidelity Special Values.
Other examples include SVS Church House Deep Value (BLY2BF0), managed by Jeroen Bos. He looks for companies trading at a material discount to their net asset value, or what Benjamin Graham called ‘net-net’ investments, where the share price offers a significant ‘margin of safety’. Interestingly the two sectors with the biggest representation in Bos’s fund right now are energy and financials.
Our preferred value funds to buy include Jupiter UK Special Situations (B4KL9F8), which focuses on large and mid-cap UK stocks, and Man GLG Undervalued Assets (BFH3NC9) which looks at companies of all sizes but has no exposure to unquoted stocks.
The Jupiter fund benefits from a manager (Ben Whitmore) with plenty of experience in running a value investing process. Its holdings include media group WPP (WPP) and industrial conglomerate Smiths (SMIN).
The MAN GLG fund looks to avoid value traps by focusing on cash, cash flow and assets. Investors should note that it can have high levels of turnover and so transaction costs can be higher than many other funds. Holdings include defence expert Qinetiq (QQ.) and refractory products provider RHI Magnesita (RHIM).