Growth and income stretched: is now the time for value investing?
For the past decade investors have opted for fashionable growth and reliable income stocks, but given their heightened valuations and with the tail wind of Quantitative Easing unwinding, has the time come for value investing?
Funds seeking out those companies delivering reliable growth and income have been highly prized by investors in the post financial crisis era, helping investors eek out steady profits in a low return environment.
Tech stocks or exciting smaller growth companies have led the way. Drinks mixer competitor Fever Tree, for example, has seen exponential growth.
But value investing – where fund managers buy cheap stocks trading beneath their market price, in the hope of a turnaround – have lagged.
In the past five years alone, the value investing strategy has significantly underperformed (MSCI UK Index against the MSCI UK Value and MSCI UK Growth indices) (click to enlarge).
In fact, according to Ryan Hughes, head of active portfolios at AJ Bell, there are fewer value managers today than there have been in the past. “The market has been focussed on growth for so long that a lot of value investors have seen their assets dwindle so they’ve gone on to something else as it’s so unfashionable”, he says.
According to Schroders, just 11% of all global equity funds under management have a value focus.
But for George Godber and Georgina Hamilton, managers of the £590m Polar Capital UK Value Opportunities fund, they’re “lucky to be swimming in the uncrowded pond that is value investing in the UK”.
Hamilton says: “We’re very lucky in that in the UK, there aren’t many value funds out there but there are lots of income funds.
“Historically people often had growth and income strategies – they thought that buying a cheap income fund covered the basis of value.
“But with QE and the hunt for yield, I don’t feel this is quite the same. If you look through the top 10 holdings of many income funds, they would differ markedly from a value fund. We hope that all three strategies are a useful blend.”
Godber adds that the UK’s been incredibly dominated by certain types of fashionable growth companies since 2000 and as such, “many more fund managers want to talk about Fever Tree rather than brick companies”.
“Human psychology naturally gravitates to the next exciting big thing, for example who has the ground breaking new drug rather than talking about dry cleaning or crash test barriers. But we love those type of companies,” he says.
‘Cheap money but stocks now at a premium’
Hughes explains that value investing has been out of favour for most of the last decade due to the impact of QE and lower interest rates seen across the globe.
“Companies were able to borrow to fund growth and tech innovation at very low rates and that has really driven market demand – business budgets have been fuelled by cheap money.
“Growth investing has been very fashionable and people are prepared to pay a premium to access a profit stream. But with many market rates on the up, it’s making borrowing for companies more expensive.”
Given the valuations, for Chelsea Financial Services, it feels like growth is too stretched now.
Darius McDermott, managing director at the firm says: “While we are mindful that, if there is a market-wide sell-off value stocks will still underperform, we believe investors would benefit from adding to their value allocation if they haven’t already. Ten years into a value ‘bear market’, when it still feels a really ‘uncomfortable’ choice, the contrarian in us can see opportunities ahead.”
While opportunities may be present, value investing can be riskier, and it certainly needs patience. But at the fore, investors need to be mindful of the ‘value trap’.
This is where something looks cheap and is a real bargain but investors discover it’s priced accordingly as the company has a whole host of issues which will only get worse, not better. Carillion would be a good example – an apparent ‘value’ stock, which had several profit warnings in the run up to its recent demise.
Hughes says: “Value investing comes with an element of risk and this is what a skilled value manager hopes to avoid – though they need to accept that every now and again, some stocks won’t work out.”
Where are managers seeing opportunity in value?
Hughes favours Man GLG Undervalued Assets fund headed by Henry Dixon. “He’s a pragmatic manager who turns his portfolio over quite a lot, with typical holdings of a year,” he says.
“Dixon picks out of favour stocks which have the ability to come back into favour quite quickly, investing up and down the market cap.”
He also opts for “classically value and contrarian” Jupiter UK Special Situations fund run by Ben Whitmore who has a “very disciplined” investment process to look for unloved stocks, focussing on large caps and he’s domestically positioned at the moment.
Another pick away from the UK sphere, is the Schroder European Alpha Income fund where the team generate yield by investing in the value space. Hughes says: “They don’t just jump on a name, they look under the bonnet to find out more information.”
What about deep value investing?
Investors should note that deep value investing is where you’re really looking at companies which are “horribly out of favour” though if the stocks can turn around, you can get some very good performance.
For Jeroen Bos investment director at Church House Investment Management, and lead fund manager of the CH Deep Value Investments fund, the return-to-volatility environment is ripe for opportunities for the value investor.
He says there are a number of value investing strategies, where managers look at low price in relation to book value, a low earnings multiple, a high dividend yield, management buying stock and corporate buy backs.
Bos, who last week marked the publication of his second book edition of Deep Value Investing explains that a good place to start is the price chart of the stock in question.
“I check that in previous periods, the share price was at materially higher levels and that the share price is, now let’s say at 50% or lower from its previous high. I don’t like to look at value stocks where the share price chart looks pretty horizontal, this to me suggests a potential “value trap”.
“I like to see a steep downward move in the share price and recent (bad) news on why the share price has tanked. It is those situations that I find most interesting. I will then have a closer look at the company, and my starting point will be the latest released results.
“I like to establish some kind of “margin of safety”. If I can buy £1 for 50p then on that basis I become interested in the company. It will now take some further investigation to establish if the current issues affecting the company are permanent or due to cyclicality, legal issues etc.”
Three stocks he finds interesting are Enteq Upstream, Hydrogen Group and Lamprell. Bos explains:
Enteq Upstream is part of the oil services sector and it listed in May 2012. At the current share price 25p, the working capital position (which is mainly cash) is equal to the current share price. Having come through the down turn well (leaving the balance sheet in a strong position) but the share price has travelled a long way down with the rest of the sector. Now that the oil price has started to appreciate again, the company is now hopeful of returning to profitability.
Hydrogen Group is trading at liquidation valuations. Hydrogen is in the support services sector and is a recruitment company. Having suffered several years of a cyclical downturn, it had a relatively large exposure to the oil sector, the company is now better balanced and is expected to return to profitability during the next twelve months.
Lamprell is part of the oil services sector and although the share price has again suffered like the rest of the sector, the company is in the fortunate position that it has a very strong and liquid balance sheet. The net asset value is roughly double the current share price at 72p. The company is a contractor/ assembler of oil rigs in the Middle East, and while the industry is still in recession, Lamprell’s strong balance sheet should protect the company in this environment and enable it to weather the downturn, being one of the survivors to prosper again, once the market starts to pick up again.