Value investing is harder than it looks

In recent months, investors have discovered what happens when the euphoria surrounding growth investing fades.

Share prices fall sharply when highly-rated companies announce disappointing results and companies without a clear pathway to profits and sustainable cash flow are severely punished.

But when the initial enthusiasm for value investing dissipates, the currently-favoured companies and sectors will also face challenges.

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That stage may not yet have been reached, but value investing has become more of a consensus than a contrarian trade. The onset of some scepticism can’t be far away.

Successful value investing is about a lot more than just ratios

The question for value investors will not be whether the stocks they favour are still cheap (they always are) – but are they cheap for a reason? It’s an easy task to divide the share price by last or current year’s earnings to get a price/earnings ratio or to compare the share price with its “book” value (net assets per share). If the result is comfortably below the market average, the stock is regarded as “value.”

This is made easier by the screening programmes used by most professional investors, but it is rarely enough by itself. A successful investment requires the identification of factors which most investors don’t see or disregard: an undervalued asset, an attractive business opportunity or recovery potential.

A change of management and corporate shake-out may change the company’s fortunes or a change in the outlook for its business may mean that business is about to boom. For example, the share prices of travel companies crashed in the pandemic but recovered when it became apparent that travel restrictions were not permanent.

Recovery stocks may represent “value”, but they are also regarded as high risk by most investors because of the possibility that they might not survive. Recovery investing can be hugely lucrative but some companies take a very long time to turn around (Marks & Spencer) or don’t recover at all (Debenhams). Most value investors prefer to wait till the risks have diminished, thereby missing much of the opportunity.

The recovery phase for pandemic-hit stocks started in the autumn of 2020 when the arrival of vaccines became apparent but suffered setbacks in subsequent phases of the pandemic. Now, ironically, the recovery opportunity may lie in the heavily out-of-favour vaccine innovators, BioNtech and Moderna, and other tech casualties.

Value stocks and sectors may be lowly-rated with good short-term visibility but the investment case is rarely straightforward.

Banks and oil stocks are popular, but for how long?

Resource stocks (hydrocarbon producers and miners) are now popular because demand is rising and supply is constrained, pushing up prices. Yet increasing resource efficiency means the consumption of resources per unit of global growth has been declining for decades.

Rising prices do not flow directly to higher profits as costs, notably of people and equipment, also rise. Ore grades and recovery rates decline until, eventually, the mine is closed and the oil well runs dry. Substitution may undermine demand growth; for example, fibre-optic has replaced copper cables and renewable energy is replacing hydrocarbons.

Governments raise royalties and taxes, depriving producers of windfall profits. Partly to avert this, producers increase investment, usually at the peak of the cycle. As with other cyclical sectors, valuations are at their lowest at the cyclical peak, so the best time to invest is when producers are struggling.

The profitability of banks is based on the margin between loan and deposit rates. A margin of at least 2% and probably 3% is required to cover costs, provide for bad debts and give an adequate return on capital, but is hard to achieve. Technology has driven down costs but also reduced barriers to new competition.

The volume of lending can be a multiple of net assets but, since the financial crisis, banks have been required to maintain larger capital bases, which reduces the return on capital. The extra revenue once earned from currency dealing, insurance and asset management has mostly disappeared while much of commercial lending now takes place through securities markets. The core business of UK banks is now the servicing of government-backed loans, such as mortgages, which makes banks vulnerable to higher taxes and bank levies.

Other financial sectors such as insurance and fund management are fiercely competitive with fees under constant pressure and customers highly mobile. Tobacco companies have done well to grow profits through consolidation and cutting costs (such as marketing and advertising) but the reality that smoking kills people means that regulation is increasing and cigarette consumption worldwide is declining.

Investing is simple, but not easy

The consumer sectors contain both growth and value businesses due to changing consumer habits, fashions and preferences. With innovation, companies can prosper but those that fall behind find it very hard to catch up. Nowhere is this clearer than in the ever-changing shape of retailing, where competition and pricing pressure have been increased by internet shopping.

Travel companies may be recovering from the pandemic but there’s always a headache round the corner – a terrorism scare, a volcanic eruption in the wrong place or an accident. Airlines have been notorious for losing money ever since the first commercial flight, but new ones are always springing up while old ones are kept afloat by governments.

Strong brands protect food and drinks companies but investors pay a corresponding premium for that protection, without which high margins in a slowly growing market are hard to sustain. Elsewhere, value usually represents corporate failure or a commodity sector without product differentiation.

Glaxo has a disappointing record of developing new drugs, perhaps because, as a large company, it has struggled to recruit innovative scientists. Telecommunication companies such as BT and Vodafone struggle to differentiate their services from each other or from competitors.

At the right price, value stocks are undoubtedly attractive, offering dramatic recovery, slow but steady growth or the switchback ride of a cyclical sector. With little prospect of more than modest growth, cash-flow can be directed to paying generous dividends, giving investors “jam today” rather than the “jam tomorrow” of growth stocks. Occasionally, value stocks will get a new lease of life and turn into growth stocks, giving investors the best of all worlds.

Value cycles, however, tend to be short. Share prices are re-rated, some stocks escape the value category and others are taken over. Value managers insist that the current upturn has several years to run; so it may have, for the investor with the right portfolio but it won’t all be plain sailing.

As Warren Buffett said, investment is simple but not easy.