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Written by: Darius McDermott
20/04/2016
After 20 years in the industry, Darius McDermott of Chelsea Financial Services says one observation consistently holds true when it comes to investing: if you buy something cheap, you've got a better chance of making money over the long term. So is value investing making a comeback?

On the whole, you wouldn’t say equities are terribly ‘cheap’ right now. Most major developed markets, with the notable exception of Japan, are trading above their long-term averages. Looking a bit more closely, however, there’s an interesting two-tier theme happening.

Investors seeking stable returns in a low economic growth, low interest rate environment have pushed up prices on high quality ‘growth’ stocks. But at the other end of the market, ‘value’ investing has been seriously out of favour.

Very broadly speaking, value companies are the market’s most ‘unloved’ companies. For various reasons, their share prices have become cheap relative to the business’s fundamental value and/or cheap relative to its history (and there’s usually something on the horizon that could trigger a turnaround). Diamonds in the rough, hidden gems, call them what you will.

Of course, they tend to be much riskier investments than the tried-and-tested growth companies that make up the larger part of the market (the problem is stocks that are cheap often get cheaper), and risk hasn’t exactly been in vogue of late.

The performance of value stocks relative to growth is now at lows not seen since late 1999–2000, when the dot-com bubble burst. Following that catalyst, value rebounded sharply relative to growth and investors who got in at the bottom would certainly have been well rewarded.

While there’s no single, standout catalyst this time round, a few factors that seem to be heralding a bit of a resurgence:

  • Firstly, investors are becoming wary of ‘overpaying’ for growth stocks whose earnings may not be able to keep pace with their share prices for too much longer. People are seeking better priced alternatives.
  • When interest rates do start to rise (it won’t happen tomorrow, but it has to happen eventually), bond yields and savings rates will follow. Conservative investors will likely revert these to ‘safer’ options, withdrawing their money from established growth stocks and making current valuations hard to sustain.
  • Many growth companies are at the high point in their life cycle, earning record margins and return on capital (consumer staples stocks, for instance). To keep boosting shareholder returns, companies are often forced to increase capital expenditure, make acquisitions and borrow to fund growth at this point in the cycle. Current valuations leave little room for error and one or two missteps may cause some speedy de-ratings.
  • Many value companies, on the other hand, are at the bottom of their cycles (stocks in the mining industry, for example). Return on capital has been low and aggressive cost-cutting strategies have started to take effect. Improving returns combined with a very low valuation is a good recipe for share price growth.

Fund picks

Without a crystal ball, no-one can say ‘value is on the verge of a comeback’, but going back to my introduction, what we can say with certainty at the moment is that value stocks are cheap.

If you are interested in being part of the potential upside, there are a few Elite Rated funds operating in this space.

For UK exposure, I like both Jupiter UK Special Situations and Artemis UK Special Situations. Both fund managers are bottom-up stock pickers with solid methodology and strong track records of weeding out the winners over the long term.

This is particularly important in value investing, as you’re dealing with a part of the market where the risk of companies disappointing or going bust is heightened compared to the average. One or two under-performers in a value portfolio are inevitable. What will really drive returns is stratospheric out-performance – and for this you need a fund manager who has the experience and confidence to make the right calls.

Meanwhile, the Schroder Income fund provides access to value stocks in some international markets, as well as in the UK. Don’t be misled by the name on this one; its returns have little correlation with other income funds. Its managers, Nick Kirrage and Kevin Murphy, invest with a deep value approach, looking for niche names outside the typical UK equity income favourites.

Darius McDermott is managing director of Chelsea Financial Services.

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