Finding hidden treasure: value investing is back in fashion
Focusing on cheap stocks, historically a highly successful investment strategy, has been a disappointment over the past ten years. But the tide is starting to turn, says Matthew Partridge.
MoneyWeek has long been a big fan of value investing, the strategy of buying "bargain" companies trading at relatively low multiples of earnings, cash flow or book value (net assets). This is because historical evidence suggests that in the long run these types of shares tend to beat the wider market. For example, Elroy Dimson, Mike Staunton and Paul Marsh of the London Business School have done research for Credit Suisse showing that equities with low price/book value (p/b) ratios have beaten the market by an average of around 3% a year in the US between 1928 and 2018 and nearly 4% a year in the UK between 1955 and 2018.
However, since the financial crisis in 2008 this relationship has broken down. Value has lagged growth, the other major investment strategy (which concentrates on stocks with rapidly expanding profits) by 3.8% per year in the USA, and by 3% per year in the UK, notes Marsh. "Cumulatively, since the financial crisis, value has underperformed growth by 35% in the USA and by 29% in the UK."
This isn't just a British or American phenomenon, since "the same pattern has occurred in most other markets around the world". Value has done a bit better than growth over the last few months, but only just. Nevertheless, the big picture is that investors who bemoaned "the death of value" in recent years were wrong. It may soon make a comeback, presenting opportunities for investors.
Why value investing has underperformed
The poor performance of value shares in recent years may be a reflection "of structural changes in the wider economy", says Inigo Fraser Jenkins of Sanford C. Bernstein. In addition to the rise of technology shares, which until recently have soared, "entire industries and sectors have been disrupted". So investors can no longer depend on the unglamorous companies that make up the majority of value shares to keep delivering. At the same time, traditional ways of valuing a company have struggled to keep up with the shift of investment from physical assets, such as machinery, to intangibles, such as software, patents and brands.
Value stocks have also encountered some short-term headwinds. Interest rates have been at historically low levels over the past decade, says Simon Gergel, chief investment officer, UK equities of Allianz Global Investors, who manages Merchants Trust. This has been much better for growth companies, for two reasons. "Firstly, a lower discount rate means that investors tend to value the promise of future profits more highly than they would normally do." Low interest rates also make it much easier for unprofitable companies to keep raising money. In some extreme cases, it can enable what Gergel terms "zombie companies" that have no chance of ever making money, but have an attractive story, to keep functioning. Nor has it helped matters that inflation has been low, so there is little prospect of significantly higher rates in future.
Gergel also reckons that the popularity of both passive funds and those that rely on growth and momentum-based strategies (these involve buying shares that have done well recently and selling those that have done badly) has led to a lot of money moving out of funds that follow a value investment strategy over the last decade.
We think that the move to passive investing is generally good news for investors because it leads to downward pressure on fees and because it is possible to buy passive funds that focus on value shares. However, it certainly seems plausible that the ascendancy of passive funds has reinforced the overall drift away from value in the past decade.
Value investing is starting to make a comeback
Whatever the reason for value's underperformance, Gergel is confident that it is set for a dramatic comeback. The chief reason is that, relative to growth shares, value shares are now cheaper than they have been for a long time: the gap between the two types of shares is at "extraordinary" levels that "haven't been seen since the early 1980s".
Gergel isn't the only one who's saying this. Bank of America Merrill Lynch recently published a study by Savita Subramanian, Head of US Equity and Quantitative Strategy, that suggests that value stocks are at the cheapest levels that they have been since 2003.
There are also other reasons to be bullish on value. Many of the cheapest value stocks are currently in cyclical industries and Gergel thinks that investors have overestimated the probability of an immediate recession and the extent of any slowdown. After all, while we've had a sustained expansion over the past decade, "it hasn't been a particularly strong one, and there haven't been any of the signs of excess that would create a corresponding bust". Central banks are in easing mode. There are also signs that the outflow of money from value funds is finally starting to reverse.
Growth stocks hit a wall
At the same time as investors are starting to take a second look at value, their appetite for growth shares seems finally to be cooling: witness the poor performance of technology companies such as Uber since its initial public offering, and the dramatic implosion of WeWork, as well as the lack of momentum in technology shares in general over the last six months. Overall, investors are starting to realise that "exponential growth rates conceal a risk" as "nothing can grow at 20% a year forever", says Tony Yarrow, co-manager of the Wise Multi Asset Income fund.
History suggests that once the likes of Amazon have been growing at high rates for a number of years, they become so big that they "start to run out of new geographies and sectors to disrupt", says Yarrow. As a result, growth starts to slow down to more reasonable levels, forcing a "substantial derating" of its share price as it "adjusts to the new reality". This slowdown within the large technology companies from the "extremely high growth rates investors have become used to" is likely further to accelerate the "revival of interest in the more pedestrian value sectors".
Avoiding value traps
Thanks to the rise of specialised exchange-traded funds (ETFs), it is possible to take a broad approach that involves buying all the shares with particularly low price/earnings (p/e) and p/b ratios in a market or sector. However, the best results come from being a little more selective, since many apparently cheaply priced shares are "value traps" cheap for a very good reason. Value investing is rather like looking in a jumble sale for "the priceless Charles Dickens love letter tucked in a pile of Aunt Dolly's old shopping lists", says Yarrow.
To avoid the chances of picking up a company with serious enough problems to cancel out the benefits of a cheap price, Yarrow advises investors to look for three things. Firstly, find "a sustainable business model", with a product or service that addresses "a core need rather than an impulse buy". A "competent, motivated management running the company in its best interests and for the long-term" is also vital, as is "a sound balance sheet, ideally with net cash". With all these ingredients present investments can still go wrong, "but a consistent focus on the essentials does seem to cut down the failure rate".
Another useful strategy is to focus on catalysts, or events that can dramatically change perceptions of a company, says James Cooke, head of global equity research at Ashburton Investments. The most direct of these is takeover interest from another company or institution. Indeed, there are signs that private-equity funds are starting to respond to the "gross undervaluation of traditional value stocks" by making bids for some of the cheapest companies. Activist investors can also play an important role in helping turn around the fortunes of a company that has been punching below its weight.
Overall, however, there is "no substitute" to fundamental analysis to understand the reasons for a company's shares being cheap, says Richard Staveley managing director, strategic public equity at Gresham House. One red flag is consistently falling sales over several years, which "usually highlights a business genuinely in decline". Firms that have taken on too much debt are also vulnerable . "It's also a good idea to wait until a company's profit levels have stabilised before plunging in."
Construction, retail and commercial property
Of course, the best bargains will always be in sectors "where others have completely lost interest", says Yarrow. At present the construction sector seems to have been written off by many as "uninvestable", even though there are many "excellent companies" in the industry and most governments are inclined to stimulate their economies through investment in large infrastructure projects.
While the collapse of Carillion nearly two years ago shows that this industry isn't without its risks, most firms have learned from similar debacles and "are no longer prepared to sign up to large fixed-price, low-margin government contracts on unfavourable terms". Yarrow also believes that there are also opportunities in the retail sector. Many firms have struggled to deal with the decline of the high street, but the success of some specialised brands shows that "there is a place alongside online retail for a revitalised physical retail as part of a multi-channel offering". Similarly, he thinks that investors have unfairly written off the commercial property sector.
Simon Gergel agrees with both assessments, pointing out that most construction firms tend to be internationally diversified, with projects around the world. Because of this, if demand in one country slows down, they can compensate by undertaking work in other parts of the world where activity is still growing. In terms of commercial property, he also notes that the London office market is "still strong" as there is still a very limited supply of office space in the capital, while many commercial property companies now trade at a huge discount to the value of their assets.
The value in emerging markets
Opportunities for finding undervalued stocks aren't limited to industrialised countries. Emerging markets look appealing on an average cyclically adjusted price/earnings ratio (Cape) of 15.1, compared with a Cape of 18.9 for developed-country equities.
As in Britain and America, "investors in emerging markets have been willing to pay a big premium for shares in growth companies", says Sam Bentley from Eastspring Investments, the Asian arm of Prudential. He notes that "a lot of value opportunities in emerging markets are in cyclical sectors, such as financials, industrials and materials, as well as technology companies that focus on hardware. By contrast, sectors like energy and healthcare are overvalued."
Then there's South Korea, on a Cape of 12.1. South Korean shares have traditionally traded at a discount owing to geopolitical concerns and the opaque governance structure of many of its largest companies due to extensive family ownership and cross-shareholdings. However, this "is starting to improve", says Bentley, while the thawing of relations between the South and the North mean that "the geopolitical risk also seems overdone". If you want to be really contrarian you could consider Chinese financial stocks: "the evidence suggests that the fears about non-performing loans have been overdone".
One reason why many emerging markets, which tend to be more dependent on trade than industrialised countries, are relatively cheap for now is that the US could impose further protectionist measures. But investors "have been too aggressive in pricing these fears in", says Bentley.
What's more, the fact that all emerging shares have been hit, irrespective of their dependence on exports to the US, creates opportunities. This is because "many listed firms in emerging markets either get most of their sales domestically, or now have a globally diversified revenue base with customers in countries other than the United States". Naturally, these companies will not be as directly affected by any increase in American tariffs. Some of the best value opportunities are highlighted below.
The value stocks to buy now
The simplest way to follow a value investing strategy is to buy an exchange-traded fund (ETF) that focuses on value shares. One ETF that offers broad exposure at a competitive price is the Vanguard Global Value Factor UCITS ETF (LSE: VVAL). This follows a quantitative strategy, selecting the cheapest 20% of stocks from around the developed world. At present they have an average price/earnings (p/e)ratio of 10.3, compared with 18.3 for the global market as a whole. The companies in the ETF's portfolio also trade at an average discount of 10% to book value (net assets). The ETF's largest holdings include Marathon Petroleum Corp, Ford and General Motors.
American stocks are at record valuations, so it's relatively hard to find bargains, but one company that looks promising for value investors is telecommunications firm AT&T (NYSE: T). Despite solid revenue growth of around 5% a year, the company trades at only 10.5 times 2020 earnings, with a very impressive dividend yield of 5.5%.
James Cooke of Ashburton Investments notes that the company's management was recently forced by activist investment group Elliott Management to abandon policies that have "destroyed value" and sell underperforming assets in the media industry, using the money to pay down debt and buy back shares.
Another global blue-chip worth considering is the mining company Rio Tinto (LSE: RIO). Its relatively low production costs give it a "big economic moat" an enduring competitive advantage, says Wise Multi Asset Income fund's Tony Yarrow. Despite its vast reserves, it trades at only 8.3 times this year's earnings and pays a dividend of 6.9%. Investors seem to believe that "a severe recession is imminent", and that mining companies will "suffer disproportionately", says Yarrow.
But they are overlooking the fact that the mining sector already suffered a recession in the middle of the current global upswing, which lasted four years from 2011 to 2015, so it should be well prepared to deal with any downturn.
The recent problems in the retail sector mean that some of the largest commercial property investment trusts now trade at a "huge discount" to their book value, says Simon Gergel of Allianz Global Investors.
For example, Land Securities (LSE: LAND) trades at a discount of just under a third. It also offers a generous dividend yield of 5.2%. More adventurous investors might consider Hammerson (LSE: HMSO), which is now trading at less than half its tangible book value and has an even larger dividend yield of 8.6%. Both Land Securities and Hammerson own shopping centres in prime locations. Land Securities also owns large amounts of London office space.
Water treatment and waste disposal firm Augean (Aim: AUG) is a company that looks attractive from both a growth and valuation perspective. Thanks to growing demand for environment-related services, revenues have doubled since 2013 and the company is forecast to keep growing over the next few years. However, a tax dispute means that it trades on a 2020 p/e of just 9.7. The underlying business is strong and Richard Staveley of Gresham House reckons that its depressed valuation makes it very attractive to a larger firm as a potential acquisition target.