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Spotting value

Value investing means being alert to the opportunities others have missed - here are the secrets that will keep you one step ahead of the pack
May 31, 2013

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.

 

 

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

DecileCompound annual returnValue of $1.00 invested on 31/12/66 at 31/12/84
1 (Lowest price as % of book value)14.36%12.80%
214.40%12.88%
314.39%12.87%
412.43%9.26%
58.82%4.98%
68.36%4.60%
77.69%4.09%
85.63%2.83%
95.26%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.

 

 

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 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.