The value detectors

What is value investing anyway?

While many investors have an intuitive feeling about what 'value investing' is, in reality it is neither easy to do well, nor is it that easy to define. As Warren Buffett, a value investing icon and former student of Benjamin 'father of value investing' Graham, put it in one of his famous Berkshire Hathaway annual letters: "We think the very term 'value investing' is redundant. What is 'investing' if it is not the act of seeking value at least sufficient to satisfy the amount paid? Consciously paying more for a stock than its calculated value - in the hope that it can be sold for a still higher price - should be labelled speculation (which is neither illegal, immoral, nor - in our view - financially fattening)."

Indeed, it would be a strange investor - regardless of their stripes - who denied that genuine growth based on sustainable high returns on capital is a wonderful and hugely valuable thing. But while trying to put an exact definition on 'value' may be something of a fool's errand, one common trait many value investors display is a scepticism about the market's obsession with 'growth', which in turn leads them to focus their attention on 'cheap' shares.

Such scepticism about growth stocks has some solid foundations based on the fact that over the long term few companies are capable of increasing in size while keeping returns comfortably above their cost of capital (growth that generates returns below cost of capital ultimately destroys value). Indeed, unless there are significant barriers to other companies entering a market, even when a business appears to be doing well, returns will normally start to look decidedly average after not that long - a concept academics and statisticians refer to as 'reversion to the mean'.

As Benjamin Graham put it when commenting on the subject of growth shares in what is widely regarded as the bible for value investors The Intelligent Investor: "Observations over many years have taught us that the chief losses to investors come from the purchase of low-quality securities at times of favourable business conditions."

Playing the psychological advantage

The problem associated with the scarcity of companies with a genuinely sustainable growth advantage is compounded by the difficulty of correctly identifying such businesses and accurately valuing their future prospects. And over recent decades the field of behavioural finance has identified a number of demonstrable foibles that suggest it's human nature to be easily hoodwinked by unsubstantiated growth stories while unjustly writing off shares in companies experiencing hard times.

A particularly noteworthy psychological trait that poses a danger to growth investors is the tendency people have to be very easily led by the first thing they hear and the 'framing' of an argument (ie if someone - whether a company boss, broker, PR, fund manager or even a well-meaning journalist - tells me I should have a look at wonderful 'growth' stock X, I'm far more likely to see investment case for X based on its growth prospects than would have been the case without the preconception).

Many of the other irrational aspects of human nature compound this issue, such as the propensity for people in general to be:

■ Overly confident in their judgments whether or not they are the result of 'framing'.

■ Too heavily influenced by the recent past, which can mean wrongly extrapolating short-term and cyclical growth stories into the future.

■ Too ready to seek out information that confirms a pre-existing view while resisting anything that contradicts.

■ Being prone to an intellectual herding instinct, which makes investors too ready to jump on a 'growth' bandwagon.

Importantly, though, many of these same behavioural traits also cause excessive disillusionment when a company has disappointed investors. What's more, negative reactions to shares in trouble may be magnified further by the fact that people have been found to pay about twice as much attention to a loss as they would to a gain of equal magnitude. The disillusionment the market feels towards companies that have been trading poorly tends to result in their shares being pushed down to very low valuations, which attracts value investors.

And just as very high growth rates often turn out to be temporary aberrations that revert to the mean, many companies that disappoint the market are ultimately found to be suffering from problems that are only temporary. This means dog stocks that have been sold down heavily can often rebound extremely strongly when trading turns.

From a behavioural finance perspective, value investors can be regarded as attempting to take advantage of market psychology by trying to identify the many stocks that have been oversold for dubious reasons, rather than taking on the tougher odds of trying to identify the few genuine growth stocks from the many stocks that have been priced for growth. The well chronicled long-term outperformance of a value investment style compared with a growth style bears out this idea (the chart below shows the MSCI World Value index versus the World Growth index over the past 50 years).

"I think we're [value investors] probably all wired the wrong way around to be honest with you," says Nick Kirrage, co-head of Schroders Global Value Equity team. "I'm one of those people that tends to get excited when I see share prices fall because I feel that, especially when things are falling very quickly, it tends to be emotional and therefore irrational."

Fortune favours the brave

The skill of the value investor is to find genuine value while avoiding so called 'value traps' (see box below). This is a fine line to walk and often the focus value investors put on finding genuine value means the issue of predicting when an improvement in fortunes will happen is regarded as an unhelpful distraction. That means value investors face the constant risk of underperforming the market as they wait for others to wake up to the value on offer. The fact that buying 'losers' goes against the brain's hardwiring can make this waiting game particularly testing. That arguably makes a clear and well thought-through investment process of particular importance to 'value' investors.

Indeed, one of the four 'business rules' recommended by the great Benjamin Graham was: "Have the courage of your knowledge and experience. If you have formed a conclusion from the fact and if you know your judgment is sound, act on it even though others may hesitate or differ."

The years following the credit crunch up to early 2016 were particularly testing for value investors as 'value' - measured by the MSCI World Value index - went through an unusually long period of underperformance, and the number of funds nailing their colours to the 'value' mast has dwindled considerably.

Joe Bauernfreund, chief executive and chief investment officer of Asset Value Investors, the management company of the British Empire Investment Trust (BTEM), says: "[Underperforming the market] is difficult and it's unpleasant but the important thing is to be aware it is going to happen and that when it happens to know you have a framework that you follow. It should give - and certainly in my case it does give - conviction that if you do the right thing, ultimately the market will prove you right. There is undoubtedly career risk, investors may leave us, clients may put us under pressure and make us uncomfortable, but that's the stall we've set out for ourselves and I think the far more dangerous thing to do is be all things to all people and try to change our style because inevitably you'll change at the wrong point." Indeed, a stunning 12 month return from British Empire following several tough years vindicates Mr Bauernfreund's faith.

VALUE INVESTING ESSENTIALS

But let's now move on to the real meat of this feature, which is not what value investing is, but what stock analysis techniques some of the UK's best value investors find most useful.

NICK KIRRAGE

Mr Kirrage has worked at Schroders since 2001 and having initially had an equity research job at the company took over management of the Schroder Recovery Fund (GB0007893760) in 2006 with his colleague Kevin Murphy. Mr Kirrage and Mr Murphy are co-heads of Schroders' respected Value team and have also co-managed the group's flagship UK equity value product, the Schroder Income Fund (GB00B3PM1190), since 2010. Mr Kirrage and the rest of his team frequently offer their insights on value investing on Schroders' 'The Value Perspective' blog; a great free resource for anyone interested in this style of stock picking.

Here's how the recovery fund has done since Mr Kirrage and Mr Murphy took charge:

CYCLICALLY-ADJUSTED-PRICE-TO-EARNINGS (CAPE) RATIO

The cyclically-adjusted-price-to-earnings (CAPE) ratio can be used to help a value investor avoid the common mistake of attaching too much significance to the recent past. The popularity of using CAPE to get around this problem and provide a long-term view is reflected in the fact that the ratio has been highlighted by Ben Whitmore of Jupiter (see Mr Whitmore's comments later in this piece) as well as Mr Kirrage.

The metric rather confusingly goes by many different names, including: the Graham-Dodd PE, the Shiller PE, PE 10 and, perhaps most prosaically, the 10-year-average PE. To add to the confusion, the ratio is probably currently best known from the work of US Nobel laureate economist Robert Shiller who analysed its effectiveness in predicting whole-market returns. That means many people regard CAPE as a ratio to be used for valuing indices rather than individual stocks. It can be used for either purpose.

In its most basic form, CAPE is simply the price of a stock divided by its 10-year average earnings (when Benjamin Graham and David Dodd came up with the idea back in the 1930s they weren't prescriptive about the exact time period of a 'cycle'). Historic earnings are also often adjusted for inflation so that the real value of EPS from earlier parts of the cycle is not understated.

The metric can be tinkered with much in the same way a normal PE ratio can. For example, Nick Kirrage and his team prefer to compare a company's enterprise value (market cap plus net debt) with 10-year average inflation-adjusted operating profits. The use of enterprise-value (EV) helps investors see things from the perspective of the buyer of the 'whole' company rather than just the part of the company represented by its equity (see box below).

Mr Kirrage says: "Many businesses are very cyclical: their profits go up, their profits go down, their margins go up, their margins go down. Many of those businesses have been around for decades and they may be around for decades to come, so valuing them off any one year's worth of profits could be a very churlish thing to do. With typical valuation metrics, such as a normal PE, just as the profits go to zero the PE goes to a very high number because you divide very low profits into a share price and suddenly the shares look very expensive. But that's not the truth. The truth is share prices tend to fall on falling profits, and if you divided that share price by the profits for the past 10 years it would reveal a business that is very cyclical but is very very attractive.

"There can be lots of reasons why the past 10 years aren't a good guide to the future, such as with newspaper stocks or other companies where there has been a structural change, so you have to be careful of using this metric in isolation. But on average the past 10 years do tend to be a very good guide to the future for most companies. It's a very powerful way to think about valuation.

"One of the things that is very interesting about cyclically adjusted valuations, and is true really of all valuations over time, is that in the market today we would perceive certain companies and industries as being demonstrably better than others. But while this sounds like a truism, the actual truth is that if you look over long enough periods of time it is not true. The companies that are perceived as high quality evolve and change.

"If you go back to 2005-06, banks were perceived as some of the best businesses you could possibly invest in, for example. This perception of quality is one that, while it seems like 'this is the way it always is', actually changes radically. So we're not keen to compare industries with their own so-called industry valuations because we do not think those are very consistent over time. That's why we look at valuation in absolute terms and we simply look at ones that are cheaper. I think that gives us a more level headed and more consistent framework for picking better companies."

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Source: Sharepad

Cash conversion

Mr Kirrage is not prescriptive in the measure used to monitor a company's cash conversion and he believes it is something that needs to be assessed over several years rather than just one. Importantly, though, given his favourite valuation metric (CAPE) is based on earnings, he wants to feel confident that those earnings are being turned into cash. Many regard this as the acid test of whether reported earnings are the real thing or effectively an accounting fudge.

The most commonly used measures of cash conversion look at profit and cash at the 'operating' level (before interest and tax are deducted in the income statement and before tax, capital expenditure and financing is deducted in the cash flow statement) and at the 'after tax' level. The important thing, though, is that the line from the income statement is assessed against a comparable line from the cash flow statement. Cash conversion is usually expressed as cash as a percentage of profit:

Mr Kirrage says: "In any one year there are lots of reasons why a business may have low cash conversion. A business may be investing or it may pay a lumpy tax payment or there could be timing issues. But if you are looking at cash conversion over rolling periods, it has to happen. So it is absolutely essential that cash, any line of cash, matches up with its equivalent line of profits. In the end, while we might value a business off profits, a business can't run off made-up profits - it can't pay its suppliers, it can't pay taxes, it can't invest in itself. There must be cash at the end.

"If a business has good evidence over a long time that its returns on capital are very good, then you'd want it to invest in its own business. Having low free cash flow isn't a problem. Equally, as many businesses grow, if they're rolling out new stores, for example, it may require commitments to inventory and working capital. A business shouldn't not open new stores just because it's a cash investment. So in the short term there are all kinds of understandable reasons for low cash conversion.

"Less good reasons for low cash conversion would be when it's not clear where the working capital is being absorbed and it doesn't fit with the logic of the group. Or where a business pays demonstrably lower cash tax than the tax on its P&L. There are lots of little tricks of the trade like this you learn over time: why the interest charge on the debt may be very different than the cash interest charge. It's not that any one of these individual things means the business is a wrongun' or poor quality, but taken together they lead to you asking the right questions about whether or not this is really the investment you think it is."

Dangerous debt

One of the biggest dangers in investing in companies that are down on their luck is that high levels of debt may prevent them from ever making up lost ground. In these situations excessive debt can be a killer. As with cash conversion, Mr Kirrage is not wholly prescriptive on the measure he uses to assess debt and the level at which he judges it to be truly dangerous will vary depending on the characteristics of the business in question. Here are some of our favourite ways of looking at debt at the IC:

Mr Kirrage says: "The risk I find by far the most serious is indebtedness. That's the risk that could permanently wipe you out as an equity holder. Someone else has financed this business and they are ahead of you in the capital structure. If things go wrong they get their money back first and you come second.

"One of the things we tend to look at, and we look at many things, is the net debt of a company versus the profits of a company, and we'd typically use earnings before interest tax depreciation and amortisation (Ebitda). It doesn't matter which level of profitability is used assuming it turns into cash - see ratio two - but trying to understand it is absolutely essential. It's like thinking about your mortgage. You've borrowed a lot of money, but what does that look like relative to the money you earn from your job? And then how much of the things you pay for day to day are really discretionary. Should you really think of your mortgage versus your salary or should you probably take off some of the things you need to live like food, the cost of transport to your job to earn that money and other bits and pieces. And it's important to think about that because the banks who lent the money will think about it and trying to get behind how they think is very important.

"The other thing I would think about is how volatile those profits have been. If profits swung about all over the place over 10 years, you should probably be quite cautious about what level of net debt you're prepared to see against those profits. If profits swing around, could that company suddenly start to look very scarily indebted? Every business in the world, given an even playing field, thinks it's conservatively financed, but every week another business suddenly looks very poorly financed after they have a profit warning.

"A net debt earnings before interest, tax, depreciation and amortisation (Ebitda) or net debt profit with banks is a bit of a meaningless concept. So what we try to understand with banks is the leverage within them. They've lent a certain amount of money and against that they hold a certain amount of capital on the assumption that some element of the loan will go wrong. If they have lent a lot more in loans than they have in capital, it only requires a small proportion of the loans to go wrong and capital, or the equity element, can go down very quickly. So we want to understand that multiple. One of the things that is quite misunderstood is that people look at that ratio of equity to lending to mean the same for all banks, but there is quite a lot of difference between me lending you payday loans money against no collateral and me lending against your house in prime London.

"If you can understand risk and compare it with the potential reward, and keep your head whilst you're doing that, then you'll probably be quite a good investor over time."

BEN WHITMORE

Mr Whitmore is Jupiter Asset Management's head of strategy for UK value. He joined the company in 2006 having previously been at Schroders. He manages the Jupiter UK Special Situations Fund (GB00B4KL9F89) and the Jupiter Income Trust (GB0004791389), as well as co-managing Jupiter Global Equities (LU0946221073) with Dermot Murphy. Mr Whitmore displays a somewhat cynical streak - often an important asset for contrarians - in not seeing much point in relying on analysts' earnings forecasts as there is very little chance of them being right, in his opinion.

Here's how the Jupiter Special Situations fund has performed under his stewardship:

Mr Whitmore's investment process starts by combining two powerful methods of sifting the market for promising ideas. These two approaches comprise his 'investment essentials'. One of the methods used is searching for stocks that appear attractive based on the aforementioned CAPE ratio. This ratio gives a long-term perspective on value, while the other technique Mr Whitmore employs is a here-and-now assessment of quality and price devised by famous hedge fund manager Joel Greenblatt.

Mr Greenblatt's so-called 'magic formula' goes to the nub of what drives stock prices in the long term: a company's effectiveness at producing profits and the price investors are asked to pay for those profits. The measures used in the formula are very focused on what companies are doing at the operating level. Mr Greenblatt strips his assessment of a company's returns on capital back to the profit being generated by the assets used in its day-to-day operations while the valuation metric he plugs into the formula is based on enterprise value, which helps give a "whole company" perspective (see box above).

The return and valuation ratio used in the formula are:

Key to Mr Greenblatt's slick system for assessing investments is his ranking methodology, whereby every company is ranked separately based on its returns and based on how cheap its shares look. The rankings are then combined to create a final magic-formula ranking. In Mr Greenblatt's highly readable and very succinct book, The Little Book That Beats The Market, in which he presented his magic formula he suggested investors simply buy the 30 highest-ranking shares suggested by the screen.

My own stock screen based on the Greenblatt formula suggests the screen works well used on this 'no-brains' basis. When I last updated the screen in mid February, the cumulative total return generated over the six years I've followed it came in at 113 per cent after factoring in an annual 1.5 per cent charge, which compared with 59 per cent from the FTSE All-Share index. The six-year result from the screen, excluding the annual charge, can be seen in the graph below:

Rather than wholeheartedly adopt the screen, though, Mr Whitmore uses it in combination with the CAPE as a kick-off point.

Mr Whitmore says: "Our process begins by screening the market for securities that meet our definition of being lowly valued. The starting point is to screen the market using two methods that we consider to be complementary.

"Most price/earnings ratio calculations are done using forecasted earnings, but the Graham and Dodd [aka CAPE] method instead uses average earnings over the preceding 10 years. This enables us to gain an insight into which securities are lowly valued in relation to their earnings power over a business cycle (of which 10 years is an approximation) rather than at any one point in time. We normally only consider stocks for purchase that trade on less than 16 times their 10-year average earnings."

"The 'Greenblatt' screen looks for companies that have the best combination of a high return on operating assets and low valuation (as measured by the ratio of earnings before interest and tax to enterprise value). For example, if there are two equally lowly valued businesses then the one that requires less capital to generate its returns is the more attractive investment.

"This screening process provides an objective list of stocks that can be considered lowly valued relative to history, and we rank them according to their combined score from the two screens. It is worth emphasising that this is not a definitive list of attractive investments, but instead is a guide to help us direct our efforts in more detailed research and due diligence."

JOE BAUERNFREUND

Mr Bauernfreund has not long been at the helm of British Empire Investment Trust. He took on the role in October 2015 after becoming chief executive and chief investment officer of the trust's management company, Asset Value Investors. While his time in the hot seat may be short, we feel the track record of the British Empire trust, which has been managed by Asset Value Investors since 1985, remains relevant due to the very focused and consistent approach that has always been followed. However, for anyone who prefers to play the man not the ball, it will be worth noting that the trust has had a superb run since Mr Bauernfreund took the hot seat.

Here is British Empire's track record since inception:

NB the author holds shares in British Empire

Big discounts for big profits

A central idea for many value investors, and one promoted by the great Benjamin Graham, is that investment decisions should be centred on an estimate of the intrinsic value of a business. There are various ways investors can go about trying to calculate intrinsic value such as calculating a company's 'earnings power' and trying to assess the value of a business's 'franchise' (its ability to sustain returns above the cost of capital). However one of the most tangible and easy to understand methods of calculating intrinsic value is the one that Asset Value Investors specialises in, which is to focus on placing a value on a business's realisable assets.

However, just because the concept of asset value is easy to understand, it doesn't mean putting the correct value on a company's assets is easy. Indeed, the reason investors like Mr Bauernfreund believe they can generate long-term outperformance with their approach is because the book value companies report in their accounts is often wide of the mark and obscures the true attractions of what a company owns.

Key to profiting from this strategy is buying shares at big discounts to the intrinsic value identified. As well as providing the opportunity to profit based on the narrowing of the discount, the practice of targeting deeply undervalued situations also chimes with the concept of having a 'margin of safety': a central idea promoted by Benjamin Graham in his 1949 classic, The Intelligent Investor. To quote: "The margin-of-safety idea becomes much more evident when we apply it to the field of undervalued or bargain securities. We have here, by definition, a favourable difference between price on the one hand and indicated or appraised value on the other. That difference is the safety margin. It is available for absorbing the effect of miscalculations or worse than average luck."

Mr Bauernfreund says: "To us value is reflected in companies trading at discounts to net asset value (NAV). Value as style means different things to different types of managers. For us, we essentially like to buy companies that allow us to buy a pound of assets for a lot less than that pound. So if you think about a company that owns a variety of different businesses, each of those businesses can be sold and can be individually realised, and if the sum of that realisable value is far more than the share price, that to us is the starting point of what value is.

"When we say tangible assets it can mean a variety of things: it may mean stakes in other listed companies; it could be stakes in wholly owned or private businesses; it could be real estate assets; it could be cash.

"To us net asset value is really looking at the realisable value of that business today, which means you have to value each of the underlying holdings. So if you take an investment trust, for instance, it's very simple, especially if it owns listed assets. It would be the realisable value of those listed stakes. When you look at an investment company that owns private equity assets or a holding company that has private assets we'd carry out a valuation of each of the private businesses and that is done by reference to listed peers and an analysis of various metric be it EV/Ebitda or a price-earnings multiple, and see how those compare with listed peers.

"We are looking at the various level of discounts across different types of companies. Not all discounts are equal. A family-controlled holding company in Europe could be trading at a 40 per cent discount and that would be very wide. But it is not our thesis that that kind of discount will disappear and go to zero. By contrast, an investment trust could be trading on a 20 per cent discount and that would be wide and there could be a very real prospect of that discount going to zero."

SHOP CLEVER

A discount to NAV is a clear-cut signal that there is a bargain on offer and the market is often quick to correct such straightforward anomalies. While clever analysis is one way an investor like Mr Bauernfreund can get ahead of the game, another approach is to be prepared to buy types of companies that the market is giving a wide berth despite the value on offer. In the case of Mr Bauernfreund that means family holding companies and closed-end funds (often ones investing in fairly esoteric asset classes)

Perhaps one of the best-known investors to propagate this idea in his book Margin of Safety (no prizes for spotting the Graham-esque reference in the title) is the man some call the new Buffett, Seth Klarman. One of the key techniques used by Mr Klarman to find investments that offer a sufficient margin of safety is to buy poorly understood assets for which there are few other buyers or a forced seller (best of all where both conditions exist).

Mr Bauernfreund says: "There are probably hundreds, if not thousands of companies that trade at a discount to the theoretical asset value. Very often those kinds of discounts are a warning sign of a value trap. The underlying assets may be of poor quality, the management of those businesses may have weak corporate governance, they could be invested in an industry that is cyclical and due a downturn, so the discount would be a warning sign to stay away.

"What we're trying to identity is mispricing, inefficiencies or anomalies, and that is companies that are trading at discounts because investors are looking at them in the wrong kind of way. So if you think about a family holding company, which is a listed entity found in Europe, Asia and parts of Latin America, they own diversified pools of assets, which often comprise both listed and unlisted assets. Many investors are turned away from investing in those companies for a number of reasons. They are controlled by families and some investors may not like to invest alongside families. The research coverage is relatively low, and often nonexistent. And the ownership structures can be quite complex. So investors tend to stay away and that leads to an inefficiency in pricing. To us, that could be an opportunity."

"The best opportunities we find are in the less known companies or better-known more-liquid holding companies that own private assets, and the private assets is where there is the potential for mispricing or a lack of awareness of the true value of the businesses."

WHY WILL THE DISCOUNT GO AWAY?

Many value investors buy value stocks in the belief that value always wins out in the end. However, the timeframe over which returns are made is an important determinant of how successful an investment is. The faster any upside comes through, the quicker profits can be recycled into other promising investments.

While Mr Bauernfreund can be regarded as a patient investor, he does like to feel confident the right conditions exist to ultimately cause discounts to narrow. In some cases, the influence British Empire has as an investor means the fund can take an activist approach to creating value. While this is beyond the capabilities of most private investors, a way around this is to look for activists, like British Empire, buying into closed-end companies on wide discounts.

Mr Bauernfreund says: "We can find things on wide discounts, but the question is why will that discount go away? We try to understand what may change for that undervaluation to correct itself. The key really lies in active ownership and activism and thinking about events that might occur to unlock the value. Those things occur in different way in different parts of our portfolio.

"If you think about a family holding company, we will never be the largest shareholder in that company, the family will always be in control. So we are investing in those businesses and are aligning our interests with them. In a sense we are relying on the family being the active owners.

"We look at the track record both in terms of the investments they've made and in terms of corporate governance. So the things that are definitely a warning sign to us are managements that have abused the rights of minority shareholders. We look at the returns based on NAV over time and how that compares with markets generally. If you think about a family-controlled holding company they tend to be quite diversified and cover a broad range of sectors and regions, so comparing those to a broad market index gives some indication of the value added over long periods of time. We look at the dividend yield they pay and how that compares with markets generally. Very often we find the long-term record of family companies is superior to that of broader markets: they pay a higher dividend, they have lower levels of gearing and value is created through that long-term active ownership and conservative perspective.

"In other cases, for example when we take stakes in other investment companies or other investment trusts, we are likely to be the largest shareholders. In those situations, it would be up to us to be the active owner and try to influence the timing of any monetisation event or any event or situation that will lead to an elimination or narrowing of the discount."

So, that's how a selection of the industry's top value investors do it. And for readers not quite emboldened enough to apply these pros' top tips directly to hunting for value stocks, there are always their funds to invest in.

To hear more from Algy Hall and the managers in this feature on what it takes to be a value investor - from the psychology through to common pitfalls - listen to our new Investment Essentials podcast: www.investorschronicle.co.uk/podcast