The most important quality for a value investor

published 4 March 2017

There are many words you might use to describe Snap, the latest over-hyped tech company to go public. The founders call it a "camera company". In this week's MoneyWeek magazine cover story, Rupert Foster describes it as "self-deleting messaging app".

But one thing you could never describe it as is a "value stock".

The first and foremost qualification for a value stock is that it is cheap. It's not hard to tell if a company is cheap or not. You look at the accounts and you look at the price, and you compare them.

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Is the company cheap compared to the earnings it generates (low price/earnings ratio)? Is it cheap compared to the value of the assets you're buying (low price/book value)? And is it cheap compared to the amount of actual cash it throws off (low price/free cash flow)?

These aren't the only ways to measure a company's value. And just because a company is cheap, doesn't mean that it's worth buying. But actually defining a company as cheap is not especially tricky.

Snap, with a $24bn market capitalisation, and at $17 a share, is not cheap. The company doesn't make a profit, for a start. Rather than hold that against it, you can look at another possible valuation metric price to sales. But even on that rather forgiving measure, American magazine Fortune reckons Snap is one of the most expensive tech IPOs ever.

This in itself does not mean that Snap won't do well. (Although Rupert doesn't think it will (he suggests some far superior alternatives in the magazine) and I certainly wouldn't touch it with my own money).

According to Societe Generale, if you had bought US stocks when they traded on a ten-year price/earnings ratio (that's a version of the p/e that's "smoothed" over ten years to take account of the economic cycle) of below ten (ie when they're cheap) then over the long run, you'd have made more than 10% a year.If, on the other hand, you'd bought US stocks trading at a long-run p/e of above 25, you'd have made less than 4% a year.

That data runs from 1880 to the end of 2009, so it's a pretty big sample and a durable effect.Yes, there have been long periods during which "growth" has outperformed "value". We've been going through one such period for a long time.

But now it looks as though things might be changing.

I went to see a value fund manager, Oldfield Partners, this week.I had a long discussion with the managers of its Overstone Global Equity fund Nigel Waller and Andrew Goodwin about value investing and its frustrations.

It really has been a frustrating time to be a value investor. Right now, on a ten-year view, value is underperforming growth more badly than at any time since the 1999 tech bubble.

However, as I said, that might be changing. 2016 saw things come good for despised stocks: commodities turned around, financials started to pick up, and there's more to come, they reckon.

Waller and Goodwin run a very focused portfolio. They typically hold between 17 and 25 stocks. At the moment, their portfolio has a big emphasis on financials (a couple of Japanese banks, plus Lloyds) and resources (Rio Tinto is in their top five, too).

That might not sound like much, but again, research shows that you only need 16 to 20 stocks to be pretty much fully diversified. Also, this is why the pair focus on big stocks - when you're buying cheap, your biggest risk is that a company goes bust. Sticking with big players gives you a certain amount of protection against the chances of that happening.

Overstone Global Equity has done well over the past year, gaining 35% versus 17% for the MSCI World Index. Since inception in 2005, it's performed in line with the MSCI World index, but that's not bad given that value in general has been struggling since around 2009.

However, what I found most interesting about our discussion was that it pointed to an area where the private investor has a real advantage over the professional.

One point that everyone I spoke to at Oldfield flagged up was the difficulty of being a value investor working for a standard fund management group. The institutional resistance to hanging on to "boring" stocks is high when the focus is on performance over the next quarter, as opposed to the next five years or more.

The characteristic that value investing requires above all else is patience. And if there's one structural advantage that you as a private investor have over the professionals, it's this ability to have patience.

You don't have someone nagging you about your returns over the past three months. Your monthly salary does not depend on how your portfolio performs this week. Your job security is not tied directly to whether or not your latest stock pick comes good.

So exploit that advantage. Don't be afraid to be unpopular. Buy value.

And the good news is that, if Oldfield is right, you won't have to be all that patient to see your bet come good.

John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.