Financial theory tells us you'll never find a £10 note on the street, because the first person to walk past it would see it and pick it up. In reality, many people will simply walk straight past the money, either too busy or too focused elsewhere to notice.
Therein lies one of the core principles of value investing - the idea that it is possible to spot opportunities that others may have missed simply by looking just a little harder. Financial market boffins tell us that value can't exist, on the basis that at any point in time all the available information has been assimilated into prices, making it impossible to beat the market – the so-called efficient market hypothesis.
Even the godfather of value investing, Benjamin Graham, questioned his own methods towards the end of his career. "I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities," he said in an interview shortly before his death in 1976. "In the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost."
Yet investors still flock to the teachings that Mr Graham originally outlined in his book, Graham and Dodd, first published in 1934. Despite his apparent later-life U-turn, value investing has often proved to be one of the most successful styles, famously employed by professionals such as Warren Buffett, Anthony Bolton and Joel Greenblatt to deliver spectacular performance over the years. Our own value-based stock screens often generate very respectable returns - when back-tested, our 'genuine value' screen on the FTSE All-Share generated a 475 per cent gain from 2003 to 2013, which compares very favourably with the 63 per cent returned by the wider index over the same period.
When value performs best
What is less well known, though, is that value performs best when markets do their worst - during the two most recent market crashes in 2008 and 2002 Warren Buffett's Berkshire Hathaway outperformed the market by 27.4 and 32.1 per cent respectively.
That, of course, also means that value techniques don't tend to do so well when markets are soaring, as they are now. The problem for value investors recently has been that 2009 onwards has been a rare period of underperformance. Mr Buffett, one of the most successful value practitioners of modern times, has come up short of the S&P 500 in three of the past five years. In his annual letter to investors, he has warned that for the first time ever Berkshire Hathaway will underperform the S&P 500 over a five-year period if the strong market rally continues.
With even the Sage of Omaha struggling, it's almost inevitable that there has been murmuring that value-based strategies have had their day. But for the value investor, five years is a relatively short period of time to hold a share - Warren Buffett once famously said his preferred holding period was forever.
And if there is indeed a negative correlation between the returns from value techniques and the direction of the wider market, value could prove a useful way to preserve capital should we see a market correction - which many think is on the way, given the likely scaling back of QE as the US economy continues to recover, Europe's continuing slump and signs of a slowdown in China.
One of the key principles of value investing is to search for a 'margin of safety' - as it happens the title of a famous book by another successful value investor, Seth Klarman (profiled in the IC in December 2012), whose hedge fund Baupost is the fourth most successful ever, having added $16bn (£10.59bn) in value since its inception in 1982.
Contrarian strategies
That's also a reflection of the contrarian core at the heart of value investing. Often, the best value is to be found when an industry or market falls out of favour, or when conventional wisdom is telling investors to avoid shares altogether. Efficient market theory does not take into account powerful emotions such as greed or fear, which can overcome rational analysis to drive share prices. "The investment world has its theories, but in the real world it doesn't quite work out like that," said value legend Anthony Bolton at the recent London Value Investors Conference (see box 'What the value pros are picking').
These all-too-human behaviours are what leads to mispricing, the holy grail of the value hunter. As JK Galbraith once said of investors, "contributing to…euphoria are two factors little noticed in our time or in past times. The first is the extreme brevity of the financial memory." And the same forgetfulness that can create financial euphoria can also create financial despair. Despair was the emotion when BP suffered its tragic accident in the Gulf of Mexico, an event which caused its shares to halve to less than 300p. Those who saw past the immediate furore - and believed that the financially mighty BP would ultimately be able to deal with whatever fallout came its way - would be sitting on a 50 per cent gain today.
Apple, meanwhile, is a company towards which investor attitudes have swung from one extreme to the other - having raced up to $700 last year, its shares have slumped by a third in 2013, and barely a day has passed in which commentators haven't attempted to rip its prospects apart.
Good companies don't stop working overnight, though, especially ones that have been as dominant as Apple. Warren Buffett, adopting his usual value-driven stance, agrees. He commented on Apple's recent troubles by saying: "You can't run a business to push the stock price up on a daily basis. Berkshire has gone down 50 per cent four times in its history. When that happens, if you've got money you buy it. You just keep working on building the value."
Indeed, its shares look cheap on many measures, but his words could apply equally to any successful value play of recent years, and certainly Buffett has also been quick to pounce when companies have run into apparent difficulties. He famously bought Goldman Sachs at the height of the credit crisis, an investment that returned his fund 64 per cent, and more recently topped up his holding in Tesco when the food retailer suffered its first profit warning in 20 years at the start of 2012.
Like with Apple, situations where there is a stampede out of a stock often throw up the best opportunities for value investors, and that's why looking closer to home at the results of a value screen published by UK value specialist James Montier in November 2009 is also instructive. Housebuilders Taylor Wimpey, Barratt Developments and Persimmon would have been on few investors' watchlists at the time, in the dark post-credit credit crunch days as the UK housing market ground to a halt as bank lending dried up.
Mr Montier observed that investors appeared to be pricing in the end of the industry - in fact, analysts were forecasting a 60 per cent decline in earnings in both of the next two years and a minus 17 per cent growth rate. "Surely this must be too pessimistic?" said Mr Montier. He was right, of course: Taylor Wimpey, Barratt and Persimmon are now up 142 per cent, 126 per cent and 180 per cent, respectively, to date, giving an average annualised performance of 42 per cent.
Value investing basics
Benjamin Graham may have ultimately decided to discredit his own system, but the core principles he once espoused are still an excellent way to determine the attractiveness of shares. Ultimately, what Mr Graham was looking for were shares whose market price traded at a large discount to their intrinsic book value.
Putting it another way, what Mr Graham was looking for was the opportunity to pay 40p for £1 - the equivalent of finding that £10 note in the street. More specifically, he liked paying 66 per cent for net current assets, the famous net-net. In other words, if a company has current assets of 100p per share and the sum of current liabilities, long-term debt, preferred stock and unfunded pension liabilities is 40p per share, then Mr Graham would pay no more than 66 per cent of 60p, or 40p, for this share. This is a similar approach applied by the IC's own value guru, Simon Thompson - you can read more of his thoughts on value strategies below in 'Why value forms the basis of my strategies'.
Roger Ibbotson, professor in the practice of finance at Yale School of Management, crunched the numbers to test the investment rule and found that buying shares with the lowest price as a percentage of book value significantly outperformed shares more expensive on this measure, as seen in the table below.
What's more, Mr Ibbotson's analysis found that returns could be boosted even further by focusing this strategy on shares with a smaller market capitalisation. Picking stocks in the lowest price to book value decile and smallest market capitalisation generated annualised returns of 23 per cent. Once again, we put this theory to the test with last week's stock screen, '21 genuine value small caps', which applied our own Graham-based 'genuine value' screen to the smaller companies indices.
Although a number of our columnists have recently questioned the predictive power of PE ratios - and it is widely understood that they should not be used as a measure of value in their own right - the metric has nevertheless proved to be another important weapon in the value screening arsenal, as Roger Ibbotson's research also showed. His work showed that stocks with a PE ratio in the lowest decile delivered a compound annual return of 14.08 per cent over an 18-year period from 1966, while the highest PE ratio stocks returned only 5.58 per cent over the same period.
What the value pros are picking
It is a strange contradiction that with the FTSE 100 now at a five-year high of 6700 - and within touching distance of the all-time high of 6930 - there is such deep uncertainty among investors. At the recent London Value Investors Conference, the pervasive view was that while governments are determined to do "whatever it takes", there is a clear lack of conviction in the verity of the results, and this has damaged investor confidence in the sustainability of the market's recovery.
So what do the value professionals, who collectively have billions under management, have on their radar? Gary Channon, chief investment officer of Phoenix Asset Management, has achieved gross performance of 351 per cent since the fund's inception in May 1998, giving an annualised return of 11 per cent. Last year his recommendation was Barratt Developments, which returned over 120 per cent in 12 months. This year he is getting excited about pharmaceuticals, and in particular GlaxoSmithKline (GSK).
Mr Channon thinks shares in the pharmaceutical giant founded in 1830 are worth £32 per share, which means compound annual returns of 14 per cent per year for the foreseeable future from today's £14-£16 levels. Mr Channon says GSK has the potential to be a "long term great". Growth in the global pharma market is well supported as the health spend gap between east and west closes. Figures from the World Bank show health spending per capita in the US and UK is $8,608 (£5,667) and $3,609, respectively, compared with $278 in China. GSK has maintained its market share for over 20 years and is one of the biggest spenders into the research that drives new drug discovery and earnings.
Mr Channon isn't the only member of the pharma fan club - Ian Lance and Nick Purves of RWC asset management focused in on Pfizer (NYSE:PFE). They think Pfizer, like British American Tobacco 12 years ago and GSK today, has the potential to be a high-quality cash compounder of the future. It's supported by research spend that is second only to GSK, but cost reductions of $5bn per year, or 8 per cent of sales, delivered over the past three years mean it has been able to complete share buybacks of $18bn since 2010. The shares trade on a PE ratio of 13 times and offer a 3 per cent dividend yield.
Simon Denison-Smith, co-founder of Metropolis Capital, has delivered annualised returns in excess of 12 per cent since the inception of the SF Metropolis Value fund in May 2008. His focus is on technology, and in particular Cisco (CSCO). Mr Denison-Smith thinks shares in Cisco look cheap, with the historic PE ratio having fallen from highs of 300 to between 11 and 12 times today. Cisco has delivered EPS growth of 13 per cent over the past 13 years, and cash flow generation is greater than reported profits, leaving estimated net cash, by Metropolis calculations, of $30bn on the balance sheet. The business has cash profit margins of between 26 and 34 per cent, which suggests that to a large extent it has been able to cope with heavyweight competition from China in the form of Huawei. That's partly thanks to its extremely defensible technology position, with an estimated 35,000 patents filed globally.
Emerging markets are attractive to many investors for their higher growth rates and beneficial demographics. Historically, Chinese equity has been expensive, leading to years of underperformance. Richard Titherington, head of emerging markets equity at JP Morgan, thinks China is in a sweet spot right now and that Chinese financials in particular have significant value potential. For the adventurous investor, Bank of China is near a record low valuation, with its shares at 0.9 times price to book - a long way from their peak at 2.9 times - and offering a dividend yield of 6 per cent; more than 2.5 times the return on Chinese government bonds.
Perhaps an easier way to tap into Chinese value is through keynote speaker Anthony Bolton's Fidelity China Special Situations Fund (FCSS). The trust has famously had a rough ride since its inception in 2010, but the veteran manager remains unperturbed. "You can find [Chinese] companies, medium sized, that have no coverage at all and are under researched," he said, a clear recognition that often the best value is to be found where no one else is looking.
Nice theory, but too difficult to do?
While Mr Graham ultimately bemoaned the time and effort it took to screen for value, today's investors do have tools at their disposal that take much of the analytical legwork out of the process. Nevertheless, passing a Graham screen is a stringent test for any share. In James Montier's 2009 book, Value Investing, he bemoans the lack of results from the screen and, with global equity markets at or near record highs, even fewer candidates make it through today.
Even so, the screen is still useful using fewer criteria. Mr Graham himself felt the first, third and sixth of the criteria (earnings yield, dividend yield and indebtedness, see 'The Graham screen in ten steps', below) he listed were particularly important.
Earnings yield compares the profit generated in the most recent 12-month period with the market value of the company, as a percentage yield. Being a function of price and profits it is a useful indicator because an elevated yield quickly highlights one of two things: the market doesn't believe those earnings are sustainable, or, and more importantly for a value investor, it has mispriced those earnings and the shares can be bought at a cheap price that will gravitate upwards as earnings are delivered and yield is bid down.
How lowest price to book outperforms
Decile | Compound annual return | Value of $1.00 invested on 31/12/66 at 31/12/84 |
---|---|---|
1 (Lowest price as % of book value) | 14.36% | 12.80% |
2 | 14.40% | 12.88% |
3 | 14.39% | 12.87% |
4 | 12.43% | 9.26% |
5 | 8.82% | 4.98% |
6 | 8.36% | 4.60% |
7 | 7.69% | 4.09% |
8 | 5.63% | 2.83% |
9 | 5.26% | 2.65% |
10 (Highest price as a % of book value) | 6.06% | 3.06% |
Source: Roger Ibbotson, Yale School of Management |
However, the levels at which earnings yields and dividend yields may indicate value are being skewed at the moment by government intervention as bond yields approach record lows. Using the UK 10-year Gilt at 1.88 per cent as our AAA benchmark rate would give a recommended trailing earnings yield of at least 3.76 per cent or a dividend yield of at least 1.24 per cent, which is lower than most cash individual savings accounts (Isas).
The analysis can be further supplemented by applying the Graham & Dodd PE ratio to try to identify those companies whose earnings are considerably in excess of their longer-term average – and may, therefore, be unsustainable. The ratio divides the current share price by average earnings per share over 10 years, thus smoothing out the peaks and troughs of earnings through economic cycles. Anything below 16 times is worth considering.
The results of his screening approach were merely a starting point for further research.
James Montier also stresses that dividend growth and dividend yield are vitally important, making up over 70 per cent of investors' returns once shares are held for more than five years, and should be the priority for any value hunter. Balance sheet measures show the level of resilience and provide Klarman's so-called 'margin of error', and making sure debt is manageable provides some measure of reassurance that a share that looks like value isn’t, in fact, a value trap. Anthony Bolton's experience supports this point. "Nearly all the stocks I lost the most on were poor balance sheet or poor franchise models," he said.
Particularly cautious investors determined to apply all of Graham's criteria can use the debt and current ratio screens to gain an idea of what might be left to the equity holders in the event of a liquidation. Equity investors enjoy the better returns in the good times but stand a long way back in the queue for assets when things go wrong - and as Simon Thompson notes below, he employs a whopping 16 risk factors when implementing his own value strategies.
The Graham screen in 10 steps
1. A trailing earnings yield greater than twice the AAA bond yield.
2. A PE ratio of less than 40 per cent of the peak PE ratio based on five-year moving average earnings.
3. A dividend yield at least equal to two-thirds of the AAA bond yield.
4. A price of less than two-thirds of tangible book value.
5. A price of less than two-thirds of net current assets.
6. Total debt less than two-thirds of tangible book value.
7. A current ratio greater than 2.
8. Total debt less than (or equal to) twice net current assets.
9. Compound earnings growth of at least 7 per cent over 10 years.
10. Two or fewer annual earnings declines of 5 per cent or more in the past 10 years.
The further screen on compound earnings, and the earnings declines check, are also worth paying attention to. By testing the earnings record through economic cycles, it's possible to ascertain a company's dominance in its given market and management effectiveness. Companies with a dominant position in a market with high barriers to entry have the power to increase prices, defending earnings through a downturn. It also hints at management effectiveness in responding to deteriorating conditions and cutting costs - a situation many of the companies that might be considered value investments are likely to face.
Of course, running the screen is only step one of the value investing approach - although value investor Joel Greenblatt's approach, for example, requires its followers to unwaveringly trade the results at specified moments, Mr Graham always stressed that the results of his screening approach were merely a starting point for further research. For investors prepared to spend time applying these measures, or some of them, there is still plenty of money left lying on the street.
By Simon Thompson
It is fair to say that my investment style is that of a classic value investor. My main approach, and one that has served me well over the years, is to target companies primarily based on the strength of the balance sheet.
In particular, I screen for companies where there is a glaring valuation anomaly between the market capitalisation and the book value of assets on the balance sheet, even though the discount is unwarranted based on the operational performance. If I can buy shares in a company for a quarter or a third less than net asset value (and in some extreme cases the discounts can be even deeper), this offers me a 'margin of safety' to limit the downside risk on my invested capital. It also enhances the chances of generating a decent return as and when enough other like-minded value-oriented investors take advantage of the valuation discrepancy on offer. This process may take weeks or months, but if the reasoning for making the investment in the first place is sound, and the rationale does not change during the holding period, then the odds are heavily skewed towards a positive outcome.
Sum-of-the-parts valuations
I take this one step further by targeting special situations where the 'sum-of-the-parts' valuations of all the businesses owned by a company exceeds its market value by a big margin. This 'hidden' value may take time to realise, but when a company is anomalously valued and its shares are trading below intrinsic value, and in some cases below the replacement value of its assets, then I am more than happy to play the waiting game if the underlying performance of the company is sound. The rewards can be eye-watering.
For instance, a decade ago I noticed that shares in consumer electronics specialist Amstrad were trading in line with its cash pile even though the company had a very profitable set-top box business, supplying Europe's largest satellite operators. This was partly due to the disastrous decision to launch a combined phone and email product, e-m@iler, which racked up substantial losses.
But it was my view that there was no way that major shareholder and founder, Sir Alan Sugar, would let the situation continue indefinitely. In the event, Amstrad slashed the retail price of the e-m@iler within weeks, and adopted a new revenue share arrangement to enable the subsidiary to build up a large enough customer base and wipe out the operating losses. With Amstrad's profitable set-top box business flourishing, shares in Amstrad soared. Within a year they had risen five-fold.
The major point to note was that even after factoring in a negative liability for the value of the e-m@iler subsidiary, Amstrad shares were being priced at a fraction of the underlying value of the rest of the business once you took into consideration the substantial cash position on the balance sheet. In fact, the distress risk embedded in Amstrad's share price was so great - and entirely misplaced - that any positive newsflow on the e-m@iler would act as a very strong catalyst for a share price rerating.
Catalysts for a rerating
The case of Amstrad highlights the important point that it’s not just a case of identifying companies that are undervalued based on a balance sheet approach to investing; you also need to be more discerning and focus on those where there is a realistic chance of a catalyst emerging to spark a share price recovery in a reasonable time frame. It also highlights the importance of focusing on companies with strong balance sheets that can overcome any short-term deterioration in trading.
It's one thing taking on operational risk, and substantial amounts of it when a company has high operational gearing, but I avoid companies whose finances are, or have potential, to be an issue. This is why I always assess whether debt levels are too high for the structure of the business as part of my investment analysis. If borrowings are too high, it constrains free cash flow generation; the ability of a company to recycle cash back into the business to grow organically and by acquisition; and prevents the board from adopting a more progressive dividend policy. It also constrains the earnings multiple investors are willing to ascribe to the net profits of a company. That's why some apparent 'value' plays are in effect being correctly priced and will always be priced below peers.
The focus on cash is incredibly important to a value investor like myself as the ability of a company to generate value for shareholders in the long run is ultimately determined by the capital requirements of the business and the cash returns generated
Capitalise on cash returns
I apply the same 'sum-of-the-parts' and book value approach to investing in assessing companies in my annual Bargain Shares portfolios. Aim-traded carbon credit investment company Trading Emissions (TRE: 31p) is a good example. The shares were priced on a substantial discount to book value when I included them in my 2012 portfolio even though the company was in the process of winding itself up with the aim of returning all the cash from asset sales to shareholders.
It was my view that even if you assumed a worst case scenario where the carbon price fell to zero and the company's private equity portfolio was sold off in a fire-sale, the shares were still woefully underpriced 16 months ago. And with disposals being made at close to book value subsequently, and cash returned to shareholders, we were rewarded with a cash dividend equating to 25 per cent of the share price. For good measure, Trading Emissions' shares have risen over 20 per cent as other value-oriented investors noted the potential for further capital returns later year, which has narrowed the deep share price discount to book value.
In the past year I have also applied the same ‘sum-of-the-parts’ analysis to investment companies Spark Ventures (SPK: 11p), LMS Capital (LMS: 74p), Aurora Capital (AURR: 38.5p) and BP Marsh & Partners (BPM: 125p). The gains made from all five have been substantial. That's because I combine another investment technique in my balance sheet approach to stock picking: focus on lowly geared or cash-rich companies, or those with substantial cash generation.
In my view, there is no better to way to focus the mind of investors on reappraising the investment case than for a company to return excess cash on the balance sheet to shareholders. So, by targeting companies where the assets are being undervalued after adjusting for cash holdings on the balance sheet, and after factoring in the returns being earned on those assets, I am cherry picking investments that have obvious potential to deliver.
Assess risk
Clearly, there are other factors to consider in value investing as not all companies wind themselves up and return large chunks of capital to shareholders. That's why I apply no fewer than 16 risk assessment tests to every company I research and pore over the finer details in the financial statements to determine whether the businesses meets my stringent investment criteria. These include an assessment of a company's debt levels, cash generation, conversion rates of cash flow to operating profit, return on capital employed compared with the cost of capital, and ability to return capital through earnings enhancing share buyback programmes, tender offers and through dividends.
The focus on cash is incredibly important to a value investor like myself as the ability of a company to generate value for shareholders in the long run is ultimately determined by the capital requirements of the business and the cash returns generated. In turn, this will influence the ability of the board to pay and grow dividends or distribute capital through other mechanisms (share buybacks, tender offers). It is also important in determining whether a company warrants being valued on a deep discount to book value or not.
In my new book, Stock Picking for Profit, I highlight all the key indicators I look for in value plays and demonstrate the other valuation techniques I use to successfully uncover undervalued companies. In no fewer than 32 case studies, I illustrate how you too can apply the same investment techniques in your stock picking. It has certainly worked for me.
■ Simon Thompson's new book, Stock Picking for Profit, is published this week. The book can be purchased online at www.ypdbooks.com, or by phoning YPDBooks on 01904 431 213. It is being sold through YPDBooks and no other source. It is priced at £14.99, plus £2.75 p&p.