Will value investors reap rewards?

Value investing focuses on buying stocks in companies that have fallen out of favour with the market and are considered cheap relative to their fundamental value, measured in terms of earnings, dividends, sales or net assets. As a result they offer investors the opportunity to make money when a recovery in the company's share price takes place.

"The past few years have seen a huge differential in performance between stock 'winners' and 'losers' with much of this driven by style factors," explains Rob Pemberton, investment director at HFM Columbus Asset Management. "Value stocks have hugely underperformed growth stocks over the past few years, offering an opportunity for investors with a contrarian streak and a high risk tolerance."

So are value investors' hard years over? The past few years have seen value style investing underperform growth investing for the longest period on record, according to a recent update by the Schroder Recovery Fund (GB00BDD2F190).

The fund's managers, who take a strongly value-focused approach, described 2015 as an "annus horribilis for value investors".

Other high-profile funds that have produced disappointing returns over the past few years include M&G Recovery (GB00B4X1L373) run by Tom Dobell and Dimensional UK Value (GB0033771766), says Mr Pemberton.

By contrast, he cites clear predictable growth winners who have delivered exceptional returns to investors, including Neil Woodford at Invesco Perpetual and now at his Woodford Investment Management, Terry Smith at Fundsmith, and Lindsell Train which runs funds including CF Lindsell Train UK Equity (GB00BJFLM156) and Finsbury Growth and Income Trust* (FGT). Mid-Cap growth biased funds which have done well include Old Mutual UK Mid Cap* (GB00B1XG9482), Franklin UK Mid Cap (GB00B7BXT545) and Rathbone Global Opportunities* (GB00B7FQLN12).

These growth biased funds tend to invest in companies that are self-sustaining and not dependant on the economy's strength for their growth; typically such companies are clustered in sectors such as consumer staples and healthcare.

It's understandable that investors have been drawn to growth-focused funds and companies in the traumatic aftermath of the banking crisis and general economic gloom, Mr Pemberton argues. These companies often offer a number of highly prized features including a strong balance sheet, consistent stream of predictable earnings, competitive advantages within their industry, strong free cash flows and a growing dividend stream.

But, as a result, the market has become starkly polarised. Investor demand for predictable growth stocks has pushed up the share prices of 'expensive defensives' and left economically cyclical and recovery companies, such as commodities and big energy companies, languishing with low share prices.

But this year the performance of value-focused funds has started to improve, leading some analysts to believe value investors are poised to reap rewards.

"Difficult as it may feel to buy them, maybe the lowly valued 'ugly ducklings' are counter-intuitively the safer investment after all with the bad news on their poor growth and earnings prospects already discounted in the share price," Mr Pemberton suggests.

Peter Toogood, investment director, and Gill Hutchison, head of investment research, at City Financial are inclined to agree. They believe that 2016 will continue to be a rocky year for the markets and caution investors planning to invest in equities to hold value-focused stocks and funds, as well as absolute-return funds for diversification.

"When we describe 2016 as the year of reckoning, it is because we see such staggering anomalies in the market," says Mr Toogood. "Value managers are fully exposed to economically exposed stocks, while growth managers find themselves party to one of the most extended momentum trades in history - overpriced growth stocks. The price that growth managers are being forced to pay for high price-earnings ratio [PE] stocks is eye-watering. High momentum stocks in the US, for example, are twice the price of the index."

He says that as a result "income managers are nervous about valuations and the potential for dividend cuts. Growth managers have nowhere to hide. Value managers increasingly have reasons for optimism but can't necessarily see the catalyst for a re-rating."

He argues that such a change in the market could come about in two ways, both of which would favour long-term value investors. "The first is a complete market washout, reminiscent of 2008, when all sectors of the market fell in tandem but value stocks outperformed - they were cheaper and no-one owned them," he explains. "The second is that global economic doomsayers are wrong and economic growth revives in the second half of the year. This is more reminiscent of 2005, when growth fears were replaced by hopes for stronger growth in the future. Value trounced growth that year."

Gill Hutchison thinks that the bull run on predictable growth companies has also been fuelled by the unusual macro-economic conditions. But she thinks a reversal or mean reversion - when stock prices return to their average prices - is on the horizon.

"These things do eventually mean revert," she explains. "The reason why it's been so extended is because of the very unusual economic environment we've been in with interest rates at extremely low levels, growth not getting started and inflation not being anything of note."

Value investing risks

Although value funds have started to pick up this year, Darius McDermott, managing director at Chelsea Financial Services, doesn't believe this indicates that the market is shifting towards value investing yet.

"Value funds have done better this year and there have been a couple of sectors that have bounced off the bottom, particularly mining," he says. "Does that mean that we are at the start of a cyclical driven market? We are not convinced."

He believes there are too many indicators that the global economy is still too weak for cyclical companies to perform well.

"We are in the greatest financial experiment in living history with unprecedented quantitative easing (QE) across the globe," he says. "The European Central Bank's announcement [of more QE] has appeared to have cheered markets, but the more QE they have to announce, the more it is a sign things are not good. In the US, rates rising is a good sign. If interest rates are rising from these historically low levels it's actually a sign that the economy is recovering, and if the economy is recovering then some of these cyclical stocks might really be the place to be.

"We think things are a bit more muted at the minute and we have the big Brexit mark hanging over not just the UK market, but the whole European market as well. So, we are in a wait and see mode on value."

In addition to the broader economic and political picture, investors also need to consider whether a company is genuinely a good value investing opportunity.

"Investors need to buy companies that have beaten up share prices but will still deliver earnings in more favourable economic conditions, as opposed to value traps which are companies in irreversible decline - whatever the economic backdrop," says Mr Pemberton.

Value funds to back

If you are persuaded by the arguments for backing value, then you could consider the following funds.

A number of analysts favour Schroder Recovery Fund. This fund is managed by Nick Kirrage and Kevin Murphy and follows a deep value approach. It focuses on companies that have had a set-back or are in struggling areas of the economy, and whose shares have invariably been heavily sold down by the stock market thereby offering a genuine contrarian or recovery opportunity. Its largest holdings all demonstrate these attributes and include BP (BP.), Royal Bank of Scotland (RBS), Anglo-American (AAL) and WM Morrison Supermarkets (MRW).

"Returns over the last few years have been a roller-coaster in comparison to the FTSE 100 Index and UK equity funds in general, but over the long term are impressive," says Mr Pemberton. "And having been one of the worst performing UK equity funds in 2015 it has been one of the best so far this year."

Mr McDermott adds: "The managers really are looking to buy the least loved stocks in the market, that's just what they do and they do it consistently."

Schroder Recovery can be bought on platforms for an ongoing charge of 0.84 per cent.

Mr Toogood suggests the JOHCM UK Dynamic (GB00BDZRJ101) and JPMorgan UK Dynamic (GB00B6X9BB33) funds, which have ongoing charges of 0.73 per cent and 0.93 per cent respectively.

"JOHCM UK Dynamic is a more pragmatically managed fund but has a notable value element within the process and indeed the manager has increasingly been dipping his toes into the value waters over recent months," he says.

"JPM UK Dynamic is equally a process that incorporates value criteria through its objective screen-based, behavioural approach and has also been increasing the value component in the portfolio recently."

See the issue of of 4 March for our tip on JPM UK Dynamic.

Mr McDermott suggests Investec UK Special Situations (GB00B1XFJS91) and Investec Cautious Managed (GB00B2Q1J816), both of which are managed by Alastair Mundy. He says: "Alastair Mundy is just totally value. He typically buys companies that have gone down by half and his funds are doing much better now as 2015 was a very poor year for value investing."

Investec UK Special Situations has an ongoing charge of 0.85 per cent and Investec Cautious Managed charges 0.84 per cent.

Ms Hutchison adds: "If you are in the multi-asset space, then Investec Cautious Managed is interesting because that's run by Alastair Mundy and the whole value thesis runs through the fund across different asset classes. If you're of a more cautious mindset, that's quite a good option for a value tilt."

She's also a fan of Man GLG Undervalued Assets (GB00BFH3NC99), which is managed by Henry Dixon: "It's really different because it's much more of an all cap portfolio," says Ms Hutchison. "It hasn't had quite the struggles that the other value funds have had because if you've been large cap value that's been the most painful part of the market, whereas all cap has been a bit better. He has struggled more recently but it's very much a value driven methodology that he uses."

It has an ongoing charge of 0.98 per cent.

She's also in favour of Jupiter UK Special Situations (GB00B4KL9F89), managed by Ben Whitmore, a fund also favoured by Mr Pemberton. He says: "Ben Whitmore is a classic value investor, buying out of favour but what he considers to be high quality companies, and then holding them for many years until their full value is appreciated by the stock market. Rather than looking for outright recovery situations Mr Whitmore sets great store on the financial security and strong industry positioning of the company. The largest positions in the fund include BP, BAE Systems (BA.) and AstraZeneca (AZN)."

It has an ongoing charge of 0.77 per cent.

Mr Pemberton also highlights Old Mutual UK Alpha Fund (GB00B946BX62). He says: "Richard Buxton has long been one of the UK's most highly regarded fund managers and is style agnostic rather than a committed value manager per se. Buxton positions his fund wherever he sees the best opportunities in the stock market and over the past couple of years has given his fund a distinct value bias, with large holdings in financials, consumer discretionary and energy stocks. Buxton was too early with this shift which hurt performance last year but his returns have been better this year as the market has begun to swing back in favour of value stocks."

Old Mutual UK Alpha Fund has an ongoing charge of 0.78 per cent.

*IC Top 100 Fund

Source: Morningstar as at 10 March 2016