Value investing is due its time in the sun

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The good times will come again

Whether you own active funds or ETFs, you must pay attention to which investment styles are working.

Investment styles matter. If you invest in smart-beta exchange-traded funds (ETFs), for instance, their very existence is based on an investment style or “factor”. That could be low volatility or value, or a combination of different factors. But it’s not only ETF investors who should care about investment styles.

Style matters

Most active fund managers tend to adhere fairly closely to a style of investing. Value investors, for instance, like to buy a stock cheap and sell it on at a profit as the market finally learns to appreciate the underlying business franchise. More growth-orientated investors prefer businesses where top-line sales and bottom-line growth are likely to increase markedly – they’re less bothered about whether the stock is cheap. But whatever tribe of investors the manager belongs to, they probably have metrics and hard numbers to plug into a model, which tells them where to go fishing for the right stock.

Those metrics probably don’t look too different from the ones used in smart-beta ETFs, with one key difference: active managers tend to invest in a smaller number of stocks (somewhere between 20 and 100 in most cases), whereas the passive ETF mechanically buys all the stocks that pass the screen in a passive fashion.

So, factors matter if you invest in funds, passive or active. But how have these different styles performed over the last few years? The first quarter of this year has been beastly for most factors, as you’d expect for a market that has started to turn a bit fearful. But certain types of stocks have done relatively well, notably those with lots of positive price momentum behind them, as well as quality and growth stocks. By contrast, those stocks paying out above-average dividends, as well as value stocks, have underperformed.

The bottom line is that value investing has fairly consistently underperformed over the last decade. The good news is that there aren’t many value ETFs, largely because they’d struggle to raise money if investors looked at the statistics. The bad news is that there are plenty of active fund managers who are in effect value types, who’ve also underperformed over the same period.

Success is often just luck

The next conclusion is also incendiary. Size-based investing has also underperformed. For years, investors have thought – backed up by academic studies – that small caps were worth the extra risk because their shares outperform other firms. Although they were right about that in the past, that extra return has started to fade. This doesn’t mean that individual small-cap fund managers won’t outperform these averages, but I’d wager that for every one who does so in a consistent, well-thought-through manner, there are two or three who turn in good numbers in any one year simply through luck.

I’d suggest two takeaways from these results. First, make sure you understand the style you are investing in. Styles can sound appealing and even logical, but then fail to deliver consistently over the long term – as value investing has done for the last decade. The second conclusion is that most trends gravitate to the average. Once we’ve all spotted superior returns, we pile in, dragging returns back to the average.

This reversion to the mean, as it’s known, will probably kick in at some point for all those fund managers and ETFs that have invested in quality stocks or stocks where there’s not as much relative volatility. They’ve done well for the last decade, but there’s a decent probability they won’t do so over the next decade, simply because the stocks might end up being too pricy. If that mean reversion does happen, there’s a decent chance that value stocks might finally have their time in the sun in the next decade. Or at least that’s the theory.


Activist watch

Leisure company Whitbread is to spin off its Costa coffee-shop chain, succumbing to pressure from activist investor Elliott Management. The demerger will be “pursued as fast as practical and appropriate”, says the company. The announcement comes just a couple of weeks after Elliott first revealed that it had built up a stake in Whitbread and would be pushing for a split-up of the company. Despite this, the company’s chief executive, Alison Brittain, told BBC Radio 4’s Today programme that the sale was taking place “because the time was right, not because of activist shareholder pressure”. Costa, which will be floated and listed as a separate business, hopes to triple its presence in China, where it is second only to Starbucks, Brittain told the BBC.


Short positions… Lindsell Train’s hefty premium

Shares in Lindsell Train investment trust, headed by Nick Train, were trading at a premium of almost 50% to net asset value (NAV – the value of the underlying portfolio) last week. The trust’s shares have gone up by 24% in the three months to 17 April, while the trust’s NAV had returned just 1%. Over the past year, the shares have traded at an average premium to NAV of 20%. The sharp increase in price is partly due to the fund’s popularity among UK investors who have been buying the top-performing fund during a period of volatility, says Kate Beioley in the Financial Times.

The illiquid nature of the trust is also part of the reason, says Beioley. Lindsell Train doesn’t commonly issue shares, meaning it has a smaller number of shares that trade less frequently and at far high prices than other trusts. The large premium can also be explained by the fund’s large stake (of 40%) in its unlisted parent investment company, Lindsell Train, which many investors think is undervalued by the trust’s stated NAV.

After a month-long rally, shares in Neil Woodford’s Patient Capital Trust fell 11% on the news that biotechnology company Prothena has failed a key drugs test, says Gavin Lumsden on Citywire. Prothena, which is Patient Capital’s third-biggest holding, announced that it was stopping further research into its treatment for the rare disease amyloidosis, prompting shares in the company to fall by 68%. The news is “damaging” for Woodford, says Lumsden. In January the manager flagged the drug’s trial as one of the key milestones that could trigger a revival in the portfolio’s performance this year.

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