Value stocks have outperformed growth stocks by 12% since Pfizer (PFE:NYSE) announced the first effective Covid-19 vaccine on 9 November 2020. That’s comparing the MSCI World Value index against the MSCI World Growth index.

We have reason to believe the value investing style could soon deliver even bigger outperformance given the shift in the backdrop from cheap money to more normalised interest rates and how that has a big impact on equities. Read on to discover why value should have a place in your portfolio.

While value might look like a winner since a Covid vaccine was developed, it is scant reward in the context of the prior 13 years which saw value underperform growth by more than 50% cumulatively based on MSCI World Value and Growth indices.

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That was the largest peak to trough fall experienced by value as an investing style since the Second World War, according to JPMorgan Asset Management.

The value investment style lost over 40% in 2020 making it the worst ever single year according to data sourced from the Kenneth French data library. Kenneth French is professor of finance at Tuck School of Business at Dartmouth College. His database identifies different factors which explain stock returns, including value, size and risk.

In a broader context prior to 2007, value has outperformed growth in every decade since 1927. Pick any year at random during that period and value had a 65% chance of beating growth.

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WHY DID VALUE INVESTING FALL OFF A CLIFF FOR 13 YEARS?

Given value’s longer-term performance it is natural to ask whether the 13-year bad patch was just temporary or if something structural had changed.

JPMorgan argues the era after the financial crisis in 2007 was an unusual period for several reasons. Firstly, it was characterised by persistently low economic growth and falling inflation expectations. When growth is scarce investors pay up for it which causes the premium attached to growth stocks to increase relative to value.

Secondly, central banks tackled low growth by artificially keeping interest rates low through quantitative easing policies – buying bonds from banks to encourage them to use the proceeds to lend to businesses.

Value tends to do better in higher inflation environments so falling inflation expectations post-2007 had a material impact on the investment style’s performance.

Lastly, the effect of cheap money (virtually zero interest rates) pushed up the value of cash flows which occur far into the future.

The combination of low growth and inflation amid a zero-interest world effectively turbocharged growth stocks. Investors scrambled to own any company which offered growth, even ones which had little chance of producing profits.

Between 2011 and 2021 the price to earnings ratio of growth stocks increased by 115% while value de-rated by 80%, based on MSCI and Bloomberg data.

As mentioned, value has made a mini comeback since late 2020 as higher inflation and rising interest rates have tipped the odds back in its favour. But growth stocks still trade at a relative valuation premium which exceeds the peak seen during the dotcom bubble.

In other words, value has rarely looked so attractive relative to growth. Could it make a huge comeback? We think so.

Asset manager M&G Investments agrees. It argues the factors supporting growth investing over the last 13 years could be ending while value has further to run: ‘In our view, the decade-long underperformance of value has not yet come close to fully unwinding.’

WHAT IS VALUE INVESTING AND WHY DO STOCKS GET MISPRICED?

At its core, value investing involves buying something for less than it is worth which has universal appeal. But in practice there is more to value investing than meets the eye.

Academics such as Ken French and index providers such as MSCI employ a purely quantitative approach to defining value and growth.

The MSCI World Value index defines value stocks using several fundamental accounting inputs such as book value, earnings per share and dividends. Stocks with low price to book, low price to earnings and high dividend yields are considered value stocks.

Sceptics focus on the use of book value (the net value of a firm’s assets after deducting liabilities) which they argue is less relevant today. That’s because most companies now have intangible assets such as brands and patents rather than simply physical ones such as plant and machinery.

While this is a valid criticism, value fund managers argue they have known this for decades and therefore do pay much attention to book value. More importantly, none of the fund managers interviewed by Shares rely on single valuation metrics.

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In partnership with ASSET VALUE INVESTORS

AVI Global Trust (AGT) offers you value with a difference.  For over 35 years AVI has followed the same distinctive investment approach, investing in:

- Durable businesses which we believe will grow in value;

- Trading at discounted valuations;

- With catalysts to unlock and grow value.

Simple and effective, AVI seeks out high quality growing assets, that are misunderstood and overlooked by other investors. AVI actively engages with the portfolio companies, and looks for special situations where companies are undergoing strategic or structural changes to unlock and grow value. This global, bottom-up index-agnostic strategy has produced attractive returns for AGT shareholders since 1985. To find out more please visit www.aviglobal.co.uk.

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IMPORTANCE OF BEN GRAHAM’S PRINCIPLES

Investment director Ben Arnold at Schroder Investment Management’s global value team told Shares the essence of value investing is taking a rational approach to assessing the fundamentals of a business and buying at a deep discount to intrinsic value.

Arnold argues value investing today relies on the same principles laid down by the ‘grandfather’ of value investing Ben Graham a century ago.

The reason companies become mispriced, explains Arnold, is because of behavioural biases which are hard for investors to overcome. Businesses and industries become ‘unloved’ because of a variety of reasons.

Arnold offers up the example of the oil and gas industry which is currently disliked because of structural threats from the green energy transition.

Fund manager Ian Lance at Redwheel suggests rather than asking why anyone would want to be a value investor the question to ask is ‘why should investors expect to earn a superior return from buying popular stocks?’ Lance and co-manager Nick Purves have more than 50 years of investment experience and manage the value-focused Temple Bar Investment Trust (TMPL).

Lance says the notion that value investors only buy ‘cheap junk’ is a misconception. The fund manager offers up one of today’s stock market darlings to make his point. A decade ago, he held shares in software giant Microsoft (MSFT:NASDAQ) when it traded on a mere eight times earnings.

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He explains the stock was unloved at the time because investors believed the business had gone ex-growth. Today the software giant trades on 30 times earnings, showing how investor sentiment can change dramatically over time.

Both Ben Arnold and Ian Lance believe the primary reason stocks become misvalued is down to behavioural biases. Contrary to popular belief all industries and stocks have the potential to become unloved and therefore mispriced.

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HOW TO GET EXPOSURE TO VALUE VIA INVESTMENT TRUSTS

The investment trust structure routinely creates value opportunities for investors as supply and demand imbalances leave the shares of many funds trading on wide discounts to the value of their underlying assets. There are also plenty of trusts that adopt a value investing style.

For example, Temple Bar buys stocks selling for less than their true worth or intrinsic value, while the Schroder Income Growth Fund (SCF) puts money to work with out-of-favour firms with potential to generate strong future returns and offers a 5.5% dividend yield.

Merchants Trust (MRCH) has increased its dividend for 41 consecutive years. Manager Simon Gergel looks to provide shareholders with an above-average level of income, income growth and long-term capital growth by investing in higher-yielding UK large caps in the main, though he does invest lower down the cap spectrum. Gergel recently described the UK market valuation backdrop as ‘a stock picker’s dream’.

Fidelity Special Values’ (FSV) manager Alex Wright has a contrarian approach, looking for unloved stocks with what he believes to possess limited downside and change catalysts, while Law Debenture’s (LWDB) managers James Henderson and Laura Foll run a diversified portfolio of companies whose long-run prospects are undervalued by the market.

Although the US is best known as a growth market, investors can gain exposure to the value theme trough various trusts including BlackRock Sustainable American Income (BRSA), which aims to deliver income and growth from a portfolio of attractively valued dividend-payers, and the quarterly dividend distributing Middlefield Canadian Income (MCT), currently on a 16.7% discount. Middlefield offers exposure to companies in classic value sectors including financials, energy and utilities.

Investors after broader exposure to the value theme can also choose from a selection of trusts which look to access growth at a cheap or reasonable price.

For example, the cautiously managed STS Global Income & Growth (STS) aims for long-run capital and income growth, with a focus on investing in large, stable, high-quality, dividend-payers.

Trusts investing lower down the market cap ranks include Aurora (ARR), which invests using a value-based philosophy inspired by Warren Buffett, Charlie Munger, Benjamin Graham and Phillip Fisher.

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FIVE VALUE-FOCUSED INVESTMENT TRUSTS TO BUY

TEMPLE BAR INVESTMENT TRUST (TMPL) 230p

Trading on a 6% discount to net asset value, Temple Bar offers investors exposure to lowly-valued names with re-rating potential, predominantly selected from the FTSE 350, for an ongoing charge of 0.54%.

Managed by Redwheel’s Nick Purves and Ian Lance, Temple Bar’s philosophy focuses on a company’s true worth. They believe investing in stocks selling for less than their intrinsic value builds in a margin of safety and in the long run the built-in value should be recognised by other investors.

Cumulative share price and NAV returns since Redwheel took over the mandate in late 2020 have exceeded the FTSE All-Share index. Top 10 positions include oil producer Shell (SHEL), retailer Marks & Spencer (MKS) and broadcaster ITV (ITV).

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ABERFORTH SMALLER COMPANIES TRUST (ASL) £11.53

Small and mid-caps should be the first to recover once inflation is tamed and the rate cycle turns. A savvy way to position portfolios for this eventuality is to invest in Aberforth Smaller Companies Trust, currently trading on a 13.3% discount to net asset value.

A value-style trust which buys shares in companies the managers calculate to be selling below their intrinsic value, Aberforth Smaller Companies has delivered three-year annualised total returns of 17.1%.

Reassuringly diversified across 78 holdings, the fund offers exposure to mid-cap names FirstGroup (FGP), Redde Northgate (REDD) and gold miner Centamin (CEY) as well as small caps including publisher Wilmington (WIL) and retailer Card Factory (CARD).

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FIDELITY SPECIAL VALUES (FSV) 259p

An 8.6% discount on Fidelity Special Values presents a compelling entry point into the UK All Companies sector’s best 10-year share price total return performer, up 92.7%.

Fidelity Special Values focuses on special situations and undervalued companies. Manager Alex Wright believes that UK company valuations remain relatively attractive compared to other markets and this has been reflected in takeover activity at a number of portfolio companies.

Wright insists the smaller end of the market cap spectrum is ‘particularly rich in investment opportunities given the lack of research coverage’.

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ODYSSEAN INVESTMENT TRUST (OIT) 140p

A year-to-date pullback presents a buying opportunity at concentrated smaller company portfolio Odyssean, which offers an attractive blend of growth and value.

Managers Stuart Widdowson and Ed Wielechowski take a private equity style approach to public markets with the aim of generating attractive total returns, principally through long-term capital growth, by purchasing significant stakes in out-of-favour firms trading at discounts to their intrinsic value.

They have proven expertise in picking companies that have subsequently been bought by private equity or strategic trade buyers. We believe the trust could be an investor favourite once small caps return to favour.

Odyssean has delivered NAV total returns of 27.7% and 48.6% over the past three and five years respectively, handsomely ahead of the 7.2% and 4.7% generated from the AIC UK Smaller Companies sector.

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SCHRODER ASIA PACIFIC (SDP) 470p

A 12.9% NAV discount on Schroder AsiaPacific should pique the interest of bargain seekers. This five-star Morningstar rated fund aims to take advantage of Asia’s domestic growth story through a bottom-up stock picking approach focused on quality companies but which are considered to be undervalued.

Offering exposure to large caps ranging from electronics giant Samsung (005930:KRX) to Chinese tech and entertainment conglomerate Tencent (0700:HKG), the Richard Sennitt and Abbas Barkhordar-managed trust invests in companies located in Asia excluding the Middle East and Japan, together with the Far Eastern countries bordering the Pacific Ocean.

With competitive ongoing charges of 0.84% and a 2.5% dividend yield on offer, the fund has an impressive long-term track record, having delivered decade-long total returns ahead of the AIC Asia Pacific sector and the Morningstar Asia ex-Japan index.

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