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Investment success doesn't come from buying good things, but rather from buying things well (Howard Marks)
Thursday 17 Sep 2020 Author: Martin Gamble

Surely every investor loves a bargain and in various ways all investors think of themselves as value investors. Sadly, what’s been working for investors since the great financial crisis of 2008 is more akin to quality and growth investing. This strategy focuses on the potential growth and quality of a business and less on valuation.

Value managers don’t shun growth, but they focus more on the price they have to pay for a business relative to expected growth. They know that for most businesses the valuation will revert back to a normal rating over time. After all, companies go through a life cycle, growing fast in the early years before fading and eventually shrinking in later years.

In the low inflation, low interest rate world of the last decade so-called new economy businesses have prospered while old economy bricks and mortar have struggled, resulting in higher earnings upgrades for the former and mainly downgrades for the latter. If you like to follow the earnings, value has been a tough ride.

James Henderson, co-manager of Lowland Investment Company (LWI) and Henderson Opportunities Trust (HOT), says the trick is to search out old economy companies that are reinventing themselves and refocusing on their strengths. These types of companies can be purchased at cheap prices because of well-known problems.

One such holding for Henderson is Marks & Spencer (MKS) which he believes is doing the right things to reinvigorate its brand and reduce its estate to get back to earning a decent profit. The joint venture agreement with Ocado (ODCO) for online groceries came at the right time, especially given the added momentum online has achieved due to Covid-19.


Academics have found value to be one of five factors that explain stock returns along with momentum, size, profitability and beta.

The chart shows the performance of value versus growth using a database created by Eugene Fama and Kenneth French who were professors at the University of the Chicago Booth School of Business.

In this case, value is defined as low price to book value and growth as high price to book.

Value has gone through long patches of poor performance in the past but has bounced back strongly such as the 138% outperformance after the 1941 trough and the 107% recovery from its 1999 trough when the dotcom bubble burst.


Value investing has proved its worth over the very long run. Based on FTSE Russell and Fama-French data, $1,000 invested in large cap growth stocks in 1930 would be worth $2.8 million today while the same $1,000 invested in large cap value stocks would be worth $14 million.

Joel Greenblatt, the author of The Little Book that Beats the Market insists that one of the reasons value investing works in the long-run is because it goes through periods of underperformance, which causes investors to lose faith. In other words, if it worked all the time, everybody would follow it and it would stop working.

Greenblatt helped to fund Michael Burry’s hedge fund Scion Capital and featured in the one of the best books on the financial crisis by Michael Lewis called The Big Short which was also made into a film with actor Christian Bale in the role of Burry.

But the underperformance of value investing since December 2006 is one of the longest and deepest stretches in its history and has led many observers to proffer that ‘this time is different’ and value will never make a comeback, despite doing so in the past.

Investment legend Sir John Templeton said those four words are the most dangerous words in finance and in 1933 they feature in his 16 rules for investment success.


Is the extreme underperformance telling investors this time really is different or should they heed Templeton’s advice, take the opposite view and buy value stocks and funds?

Bank of America is in the camp which believes conditions are ripe for value to come back to form. In a recent note it said: ‘We expect global manufacturing trends to turn sharply positive over the coming months, consistent with a rise in bond yields, just as has been the case in every recovery over the past 20 years. If bond yields increase in line with our expectations, this would imply 20% plus upside for value versus growth stocks.’

In the other camp is an even larger contingent who believes the current low interest rate environment is here to stay and value will continue to struggle.

While the academic evidence supporting a ‘value style’ of investing is clear, the applications of this style of investing are varied and you won’t find any investment firm that solely uses price to book ratios to build portfolios.


American economist Benjamin Graham, born in 1894, wrote two of the most important books on investing – Security Analysis with David Dodd, and The Intelligent Investor which Warren Buffett described as the ‘best book on investing ever written’.

Graham applied logic and rigour to the world of investing and was one of the first to separate stock market sentiment from the fundamentals or economic factors that drive company earnings. He did this by introducing his Mr Market analogy.

Mr Market is either deeply depressed or crazily exuberant and every day he offers to buy your shares at either a huge premium or on a huge discount. Graham cautioned investors that Mr Market was to serve them and not to inform them. What mattered was intrinsic value.

Intrinsic value is based upon the future earnings power of a business and isn’t nor should ever be a precise value. Ideally, it should be materially higher that the current market price, providing what Graham called ‘a margin of safety’, which Buffett says are the four most important words in investing.

Buffett studied under Graham at Columbia University as did John Templeton. Graham later introduced a formula called the Graham Multiple. This is probably one of the first mathematical models used to estimate intrinsic value.

Buffett went on to practice Graham’s methods when he started his investment partnership in 1956 to good effect. He often referred to his value style as the ‘cigar butt’ approach or the equivalent of finding a discarded cigar which has a few free ‘puffs’ left, and which you then discard.

Graham managed his own investment partnership and later Buffett offered to work for the partnership for free, but Graham turned him down. Buffett joked that his price was too rich for the value-focused Graham.


The most important point about Graham’s approach and the reason it is followed by value managers is that it is based on a full fundamental analysis of a business and its prospects that encompass both problems and opportunities. None of it can be boiled down to a number or single metric.

Buffett eventually moved on from cigar-butt investing, influenced by his long-term business partner Charlie Munger and the investor Philip Fisher, who wrote the book Common Stocks and Uncommon Profits in 1958.

Buffett has said in the past that growth and value are ‘joined at the hip’, meaning an evaluation of future growth should always form part of the analysis in arriving at intrinsic value.

In Buffett’s view, separating value and growth makes no sense, but the investment industry has built a profitable business peddling the idea of style investing.

In the 1990s so-called quantitative managers built on the Fama-French data to create multi-factor models and today quant managers control over $1 trillion of assets. The value factor for them is a characteristic feature of a stock rather than a fundamental assessment of the business.


Terry Smith, the founder of asset manager Fundsmith, often quotes Buffett and clearly likes to think of himself as a rational investor. Like Berkshire Hathaway, Smith has produced an owner’s manual outlining the buy and hold strategy for Fundsmith’s various funds including the popular Fundsmith Equity (B41YBW7).

Fundsmith’s strategy is to seek out high quality businesses which have sustainably high returns on capital because it looks to earn its return from the increasing value of the business. For this to happen a company needs growth opportunities and to reinvest a portion of its cash back into the business. This compounding of returns is what drives stock value.

Smith says he looks for businesses with lots of intangible assets because unlike physical assets, they are harder for competitors to replicate and therefore act as barriers to protect high rates of return on capital. The sorts of intangible assets he seeks are brands, patents, proprietary databases and client relationships.

Businesses with a lot of intangible assets tend to trade at high price to book ratios because they own fewer tangible assets and as a result require less equity. On that basis they would fail to qualify as value under classic rules used by Fama-French.

Smith insists that he won’t buy quality businesses at any price because of the risk of underperformance. Implicitly the fund manager is adopting a margin of safety and value approach to his quality investing. 


Book value is based on historical costs which fail to reflect the true value of a company’s assets. Albert Einstein once wrote ‘not everything that counts can be counted and not everything that can be counted counts.’

Most businesses today have more intangible assets like brands and databases than tangible assets such as plant and machinery. But accountants have yet to come up with a reliable way to put a value on intangible assets in the same way they do for tangible assets.

There are brand consultants who estimate brand value by looking at brand recognition, marketing expenditure and contribution to financial performance. For example, Amazon is thought to be the world’s most valuable brand, worth around $220 billion, but you won’t find that figure on the balance sheet. The accounting book value is $62 billion while intangibles and goodwill are $14 billion.


There are an increasing number of companies which have negative equity, which means they cannot be measured using price to book value. For example, breakdown services company AA (AA.) has consistently had negative book value since coming to stock market six years ago.

This means it doesn’t qualify as cheap on price to book, but on other value measures like price to earnings (2.8 times) and price to sales (0.2 times) it offers value.

US-based O’Shaughnessy Asset Management has analysed the increasing number of negative book value stocks in the US and some of them rank cheap on alternative value measures.

O’Shaughnessy calls these stocks ‘veiled value’ because they look expensive but are cheap, the opposite of ‘value traps’ which look disarmingly cheap but are expensive. The asset manager calculates there are over 258 veiled value stocks in the US worth over $3.9 trillion of market value.

This underscores the importance of using a range of metrics rather than relying on a single measure.

Understanding the Graham multiple

Value investor Pzena recently purchased a 5% stake in J Sainsbury (SBRY), so let’s use that as an example to see how Benjamin Graham’s formula works.

Intrinsic value = earnings per share, multiplied by
(8.5 + 2 times the long-term growth rate).

Inputs: EPS 18.7, Growth 3%

Intrinsic value= 18.7p times ((8.5+ (2*3)) = 18.7*14.5= 271p

Sainsbury’s share price is currently 185p = 32% discount

We used 2021 consensus earnings because it is lower than the 2020 outcome. For Graham a 32% discount would probably qualify as sufficient margin of safety.

Screening for value stocks

The most reliable way to a screen for value is to use different metrics in the search rather than looking for a single magic bullet. If a stock appears to offer value on different measures, you are on safer ground.

To give readers an idea of the current opportunities, Shares used Stockopedia to screen for UK stocks that met the following criteria: market cap over £100 million, cheapest 25% on forward price to earnings, cheapest 25% on enterprise value to EBITDA, and the cheapest 25% on price to book. We excluded financial stocks.

Enterprise value measures the total value of the business including net debt or cash. EBITDA stands for earnings before interest, tax, depreciation and amortisation and is a measure of the cash flow a business generates.

Among the other ways to screen for opportunities is a Ben Graham quantitative approach called the Enterprising Investor.
The criteria is trailing PE below 10, current ratio above 1.5, long-term debt less than 1.1 times working capital, EPS streak greater than four years, dividend paying, trailing EPS greater than five years ago, price to book less than 1.2 times.


National Express (NEX)

Price: 120.1p
Market cap: £727 million

The travel sector has been badly hit by coronavirus for obvious reasons and bus, coach and rail operator National Express (NEX) has been no exception.

In our view this has created an opportunity to buy the market leading operator at a knock-down price of around 7.4 times 2021 earnings and an EV/EBITDA of 4.5 times based on Berenberg forecasts.

National Express satisfies two of the three filters on the first of the two aforementioned screens; it just falls short on the EV/EBITDA ranking. Investors should appreciate that these screens are used as a tool to reduce the universe to the most promising candidates.

While there are some question marks over the pace of National Express’ recovery there are other catalysts for the shares which appear to be underappreciated by the market.

These include growth in its North American school bus operation where the impact of Covid-19 on public finances potentially prompts an increase in outsourcing.

There is also an opportunity to grow its shuttle bus operation for companies, universities and hospitals in the US. The company’s WDU business, acquired for $84.3 million in 2019, provides this service to large corporations in Silicon Valley such as Facebook. National Express is also building on an already strong position in Morocco.

The fact that around half of group revenue is contracted – essentially it gets paid even for services which haven’t been running – plus compensation received on its UK bus routes, intended to protect a societally important service, means it has a measure of breathing space.

The company remained EBITDA positive in the second quarter of 2020 at the height of lockdown. While its net debt isn’t insignificant and could hit six times earnings in 2020 according to Berenberg, this looks like a temporary issue and its net debt to EBITDA covenant has been waived until December 2021. Berenberg expects the ratio to fall to 2.6 in 2021 and 1.6 in 2022.

Kenmare Resources (KMR)

Price: 235.39p
Market cap: £258 million

Mineral sands miner Kenmare Resources (KMR) is a significantly undervalued stock whose shares could see a sizeable re-rating if it can complete a capital project that will enable its production to soar.

The company is moving a wet concentrator plant in Mozambique to an area where it will mine significantly higher-grade ore. It says the project is 70% done and hopes to have the plant relocated and for mining to begin in the fourth quarter of this year.

This the last of three big capital projects Kenmare flagged in 2018. It will enable the company to produce 1.2 million tonnes of ilmenite a year, a 35% increase on its 2019 level, and given its fixed cost base is also expected to drive profit margins higher.

The miner trades on a price to book value of just 0.4 times according to Stockopedia, significantly lower than other miners and almost half the valuation of its Base Resources (BSE:AIM), another mineral sands miner on the UK stock market.

There are risks to buying the shares, such as if Kenmare has problems with the plant relocation and forecast weakness in the ilmenite market in the second half of this year. But expectations for the business are already low, and if can complete its latest project – and unlock higher revenues while keeping costs stable – the miner stands a chance of winning the support of more investors and for its shares to trade on a higher rating.


For investors who don’t feel comfortable choosing individual shares it’s possible to get a broad exposure to the value style via funds. We like the look of the following investment trusts and exchange-traded fund.

Henderson Opportunities Trust (HOT)

Price: 851p
Market cap: £90 million
Yield: 2.9%
Discount to NAV: 17.9%

The £90 million trust aims to achieve capital growth in excess of the FTSE All-Share index by investing in 70 to 100 stocks with a strong bias towards smaller, early-stage companies that hold growth potential. The co-managers James Henderson and Laura Foll employ a value style that involves investing in out of favour or under-researched companies trading on attractive valuations.

Over the last 10 years the net asset value of the trust has delivered an average annual return of 9.9% a year which is handsomely ahead of the Morningstar category benchmark of 6%. On the same basis the trust’s shares have delivered 10.7% versus 6.25% for the benchmark.

The fund’s largest sector weighting at 25% is in industrials suggesting plenty of exposure to value stocks. Technology and financials, another classic out of favour value sector, make up a further 39% of the trust’s assets.

The largest holding (3.7%) is in RWS (RWS:AIM), a leading language and localisation provider, which is merging with SDL (SDL) to create the largest language services and software company in the world.

The investment trust’s management fee is 0.55% of net assets and the ongoing charge is 0.91%. The trust has net gearing of 14% which could amplify gains and losses.

Fidelity Special Values (FSV)

Price: 178.3p
Market Cap: £514 million
Yield: 3.2%
Discount to NAV: 11.5%

Managed by Alexander Wright and Jonathan Winton, the trust aims to achieve long-term capital growth through investing in UK companies the managers believe to be undervalued or where the potential has not been recognised by the market.

The NAV has grown at an average annual growth rate of 7.15% a year over the last 10 years, similar to the 7.2% growth in the price of the trust and ahead of the Morningstar category benchmark of 5.92% and 6.15% for the NAV and price respectively.

The trust’s largest sector allocation is to industrials (23%), with consumer cyclicals and financial services at 13% each, suggesting good exposure to the value part of the UK market.

Insurers Legal & General (LGEN) and Aviva (AV.) are the two largest holdings with around 4.5% in each. Also featuring in the top 10 is tobacco company Imperial Brands (IMB) and outsourcer Serco (SRP).

The trust has a net gearing of 14% which means it has borrowed money to invest. That can work in its favour in strong markets but exacerbate problems when markets are declining.

The management fee is 0.85% of net assets and the ongoing charge is 0.96%.

iShares Edge MSCI World Value Factor UCITS ETF GBP (IWFV)

Price: £21.03
Market Cap: $1.7 billion

Managed by BlackRock, this value factor exchange-traded fund is the largest in the passive value space and provides investors with global exposure to a diversified portfolio of large cap value companies.

Launched in 2014 the ETF has delivered an average annual return of 5.8% over the last five years, lagging the Morningstar category benchmark of 7.78%.

The performance difference is explained by the fund’s geographical exposure which is split between the Americas (38.5%), Greater Asia (33.8%) and Europe (27.7%), meaning the fund is underexposed to the Americas and overexposed to Asia and Europe compared with the benchmark.

The industry exposure shows an overweight towards economically sensitive sectors and cyclical companies at the expense of consumer defensive stocks. That positions it well should markets rotate towards value.

The top 10 holdings include US chip maker Intel, telecommunications giant AT&T and computer services company IBM. The UK’s British American Tobacco (BAT) also features in the portfolio.

The ETF charges an annual management fee of 0.3% of assets.


Editor Daniel Coatsworth has a personal investment in Fundsmith Equity referenced in this article

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