Value investing in the current era

Does it have a future?

Value investing has been out of fashion for a number of years while growth stocks have come to the fore, most notably with the tech boom.

But this means that stocks have not been following conventional stock market investing rules.

This is due to the conditions created by the extraordinary measures taken by central banks to support the economy as the global financial system came out of recession, from the financial crisis of 2007/8.

More recently, well known value investors, such as Neil Woodford and Mark Barnett have fallen from grace, but does this mean we have reached the bottom of the value cycle?

Investors may be trying to decide which way to go, as economic indicators look confusing, and predictions for the global economy difficult to make.

In this report we look at some of the issues around value investing, and where value investors go from here.

Value funds have generally underperformed growth in recent years, with the IA UK Value sector underperfoming the growth sector by 30 per cent in the three years to May 22, according to data from FE Analytics. 

The pressure on value funds has been exacerbated by the negative publicity around the collapse of the investment empire of Neil Woodford, a value investor, and the underperformance of the Invesco Income and High Income funds, run by Mark Barnett, who subsequently left the firm.

Value funds tend to perform better when interest rates are rising, inflation is rising and the pace of economic growth is picking up, conditions which have not existed in the UK for some time.

But advisers are largely sticking with the value funds they own, according to the latest FTAdviser poll.

See the poll results below: 

The data shows 60 per cent of advisers intend to keep their present allocation to value funds in place over the past year, while 30 per cent of the advisers who responded to the poll. 

When looking at value you do need to distinguish between sectors such as financials and everything else
Ben Yearsley, Fairview Investments

Ben Yearsley, investment director at Fairview Investments says that in the UK many of the traditional value stocks are owned by investors because they tend to pay large dividends, but with many such businesses unwilling or unable to this year, he feels value stocks in the UK will continue to struggle until there is some normality around dividends.

He says: "When looking at value you do need to distinguish between sectors such as financials which admittedly make probably the largest value segment and everything else.

"Financials are going to find it very hard making headway over the next decade, in my view, as interest rates are simply not going up. 

"Even in the face of higher inflation I can’t see central banks pulling the trigger in any meaningful way.

"Having said that, I do think some of these stocks look astonishingly cheap today and could easily have a short term rebound; it’s just a longer term bull market for value seems harder to see occurring."

Mr Yearsley added: "In the UK we have a different problem in that value was obviously synonymous with dividends and many of those have been cut or deferred. 

"So that probably rules out a rebound for 2020 as companies won’t be rushing back to the dividend register this year."

Where next for value investing?

Words: David Thorpe
Images: Fotoware

For about 60 years from the end of World War II to the onset of the Global Financial Crisis in 2007, value stocks consistently outperformed growth, but since then it has been growth’s turn to rabidly outperform value. 

Growth equities tend to perform better when inflation is low, bond yields are low, and interest rates are low.

When those macroeconomic factors exist, it is extremely likely that the rate of economic growth in an economy will be low, and so the number of companies that are growing will be small.

In such a climate, investors favour the few companies that are growing earnings, and pay relatively less attention to the valuations of companies, as such an economic situation has historically happened when coming out of a recession, and so the stock market will typically be cheap when investors begin to buy growth stocks.

As the economic recovery expands, more companies start to grow, inflation rises, and the stock market rises.

With more companies growing, investors pay less attention to growth, and more to the price they are paying for the growth, or the valuation of the company. This is value investing.

Unpredictable markets

As the world limped out of the global financial crisis, a small number of companies were growing, which could be divided into two groups, the high growth technology companies, mostly in the US, and the low, but predictable growth delivered by fast moving consumer goods companies such as Unilever.

But the next stage of the cycle never really happened, economic growth remained weak, before turning negative when the pandemic struck, and inflation and bond yields remained low.

The outlier may be that central banks responded to the global financial crisis by pursuing a policy known as quantitative easing, which caused bond yields to fall to record low levels, but also means that inflation, and economic growth remained low. This meant the traditional rotation out of growth and into value did not really happen.

Policymakers' response to the economic emergency provoked by the Coronavirus pandemic has been to cut interest rates even further, and increase the volume of quantitative easing.

I think it is difficult to see value outperforming strongly in the near future
Ian Heslop, Merian Global Investors

Ian Heslop, head of global equities at Merian Global Investors, says: “It is hard to argue with the idea that if low interest rates and quantitative easing are behind the outperformance of growth stocks over the past decade that a continuation of those fundamental conditions will mean the same outperformance.

“So I think it is difficult to see value outperforming strongly in the near future.”

Impact of the fiscal response

Stephanie Butcher, chief investment officer at Invesco says the circumstances in the years ahead will be different to those of the past decade because the policy response to the economic crisis of the pandemic has included a fiscal response, that is, major increases in public spending by governments. 

I believe the price you pay for a stock matters
Stephanie Butcher, Invesco

Ms Butcher’s view is that this extra spending will help achieve a broader based economic recovery, and this creates precisely the conditions in which value investing thrives, as the economic growth is effectively spread out among more companies. She added that while growth investing is presently fashionable: “I believe the price you pay for a stock matters.”  

Mr Heslop adds that one of the problems with using traditional valuation metrics to assess the relative merits of typical and growth and value stocks does not take full account of tech companies' business models.

This is because, when most large technology companies expand, they do so by hiring more people. The cost of this immediately and entirely goes onto the balance sheet of the company.

When an industrial company or an airline expands, this often involves buying new machinery or aircraft, the cost of which is amortised in the accounts over multiple years, which means the impact on short-term profit and loss is spread over multiple years.

Mr Heslop says this can make technology companies which are “growth companies” look relatively less profitable compared with companies that usually fit into the “value” segment, something which traditional valuation metrics cannot take into account. 

Matthew Beesley, chief investment officer at Artemis, acknowledges that many of the fundamental issues cited by growth investors are real, but says the “elastic has stretched so far” in the gap between the value and growth sectors that the fundamental challenges are already reflected in the share prices.

He says: “Data shows that value has only been this cheap relative to growth once in the past hundred years. It could be that the change happens because that elastic snaps as the valuation gap is just too much, or it could be that the fundamentals change.”

Growth has outperformed

Mike Coop, investment manager at Morningstar says that while growth shares have generally outperformed value in recent years, the growth has come from share prices rising relative to profits, rather than profits rising.

He says: “There has not been a big sea change in terms of the profits the typical growth companies are achieving, and alongside that there has been a great tolerance in the market for companies that are not making a profit.

"But I think in recent months, perhaps with WeWork, we have seen the tolerance for companies that don’t make a profit reverse, and that could be the start of a trend which helps value shares perform better.”

Growth equities can be divided into two buckets, the “fast-growing” technology companies which are mostly located in the US, and the “steady reliable” growth companies that are a feature of the UK market. 

James Thomson, who runs the £2.2bn Rathbones Global Opportunities fund says that many of the traditional growth companies could benefit from a rebound in consumer spending, as people exit lockdown.

He says consumer goods companies such as L'Oreal can benefit from the shift to online retail and any economic recovery.

Reputational damage

Many of the large technology companies have suffered reputational damage - over data sharing and competition issues - in recent years, and have been under almost constant threat of regulatory intervention.

But Mr Thomson believes that technology companies such as Amazon will benefit from a change in the public sentiment towards those companies.

If some of those companies were to be broken up, then that might actually be better for shareholders
James Thomson, Rathbone Investment Management

He says:  “Amazon has been a lifesaver for many people during the lockdown, while people’s attitude to test and trace apps indicates that maybe they are now more relaxed about sharing data, and that will help the image of those companies.

“I would also say that if some of those companies were to be broken up, for example, Alphabet, which owns Google, then that might actually be better for shareholders.”

He says that while he is generally cautious on the outlook for value stocks in the years ahead, “there will undoubtedly be periods when value stocks perform very well.”     

Hugh Seargeant, who runs the UK Recovery fund at River and Mercantile, a fund that uses the value style of investing, says: “These things go in cycles, and value will have a turn when it is outperforming.

Disruption has always been with us, it will be the case that some bricks and mortar retailers don’t recover, but not all of the stocks in the value category are disrupted
Hugh Sergeant, River and Mercantile

“But I think it is important to understand that with the pace of disruption in the world it will not be enough to just buy stocks that have fallen in value.

“Disruption has always been with us, and just as in the past when some traditional businesses such as textiles fell in value, and didn’t recover, it will be the case that bricks and mortar retailers don’t recover, but not all of the stocks in the value category are disrupted. It is hard to see for, example, how UK house builders are disrupted, in fact there are a lot of structural factors that suit house builders, but the share prices are cheap.”

Ian Lance, who runs value funds at RWC says that “the traditional growth stocks like Diageo cannot keep going up forever.

“It is true that the share prices of those companies perform well when bond yields are low, but I think at this stage that is already reflected in the share prices. The biggest mistake investors make is believing they can predict the future.”

Julian Howard, head of multi-asset solutions says he expects the strong performance of growth stocks to continue into the future, and says from an investment point of view “this points clients away from the UK, which is a value market, and more towards the US which is a growth market.

“It is hard to see how value can outperform unless interest rates rise, and it is difficult to see that happening soon.” 

The bottom of the value cycle?

James Burns, who jointly runs the model portfolio service at Smith and Williamson says that while it is reasonable to believe that growth can continue to outperform, there have been recent events that imply that we have seen the bottom the cycle for Value.

He noted that in recent weeks two of the best known value fund managers in the UK, Mark Barnett of Invesco, who has left the firm, and Alistair Mundy of Investec, who has taken a leave of absence from his role, may come to be viewed as the bottom.

He added that the collapse in the oil price in March, may also be seen as the bottom, after which value stocks began to perform better.

He says that while he does have some value funds in his portfolios, and can see catalysts for why it might soon be time to invest more into value, but adds that “now is not really the time”, as he wants to see more evidence.

Simon Evan-Cook, who jointly runs a range of multi-asset funds at Premier Miton says the relative lack of managers who are happy to describe themselves as “value” in the current climate is itself a sign.

20 years ago it was hard to find a manager that was happy to describe themselves as growth
Simon Evan-Cook, Premier Miton

He says: “Twenty years ago it was the opposite way around: it was hard to find a manager that was happy to describe themselves as growth, and subsequently growth strongly outperformed. I don’t think it is a good idea to have all value or all growth funds in a portfolio.

“We are slightly overweight value now. In truth, while growth has generally beaten value for the past decade, its really only in the past two years that even the very good value managers have not been able to outperform, but we continue to own those good managers, like Henry Dixon at Man GLG and Jonathan Pines at Hermes.”

Financial strength should now be recognised as the plus it always was

Depending on your cultural reference point of choice, you might recognise ‘Everything changes’ as a quote from the Roman poet Ovid’s Metamorphoses or the title of a number one single and album by Take That.

Either way, the phrase is also a neat summary of one of the foundation stones of value investing – times, fashions, people, tastes ... everything changes.

What that means is, if you have a process that enables you to identify good yet unloved businesses – as well as the mental fortitude to buy and hang onto them when others are selling – you should profit as the pendulum swings once more in your favour.

As the American Economic Association highlighted in a 2014 paper, From Sick Man of Europe to Economic Superstar, this happened in the early part of the last decade with Germany.

Looking ahead, we now believe something similar will occur with Japan. Yes, we know some people may find that hard to swallow – after all, over the last decade and more, Japanese companies have been the target of huge amounts of ridicule on account of their balance sheets.

To be clear, this was not because they were weak but because they were seen as ‘unnecessarily’ strong.

An odd concern

For much of the last decade, when markets were often inclined to reward businesses that took on cheap debt, that was at least an argument – albeit one we never found persuasive, as we have explained in articles such as Tackling concerns about rising debt levels by way of a rugby analogy.

With markets and businesses now hit by the Covid-19 pandemic, however, concerns about overly strong balance sheets look especially odd.

Now that times have changed again, investors really need to be reconsidering their stance on the importance of companies’ financial strength.

Certainly one can imagine the many highly leveraged businesses in the US and Europe looking enviously at their Japanese counterparts, whose cash reserves – as this Financial Times article puts it – “are now a great source of advantage”.

In the interests of balance, it is worth noting the author of that piece, Jesper Koll, has been researching and investing in Japan for more than 30 years – but presumably that also means he knows what he is talking about when he observes: “Japan’s listed companies went into this crisis with the biggest cash reserves ever recorded.”

‘War chest’

“Collectively, they had slightly more than $6.5 trillion [£5 trillion] of cash and short-term securities on their balance sheets at the end of December, according to data I tallied from the Tokyo Stock Exchange,” Koll continues.

“This war chest amounts to more than 130 per cent of the country’s gross domestic product: more than three times the equivalent ratio in the US.”

Despite the adverse environment they now face, then, Japanese businesses will still be in a position to invest in both capital expenditure and research and development.

They will still be able to remunerate staff and pay dividends for far longer than companies anywhere else in the world.

And, as Koll argues in his article, this state of affairs may well also lead to a surge in merger and acquisition activity, both in Japan and abroad.

As we wrote recently in Why balance sheet strength should interest investors more than ever, this aspect of a business has always been a major focus for us, here on The Value Perspective.

Over the last year or so, that has led to us increasing the exposure of our global portfolios to Japanese companies – with the remarkably high calibre of their balance sheets being matched only by the remarkably low nature of their valuations.

In effect, then, we have been buying what our own analysis tells us are winners at the price of losers – and then waiting for everything to change

Simon Adler is a fund manager in the value team at Schroders