Value style investing has never outperformed growth style investing during periods of market dislocation. However, this is arguably the best time to buy into value stocks and the reason why Hugh Sergeant, manager of River & Mercantile UK Recovery (GB00B614J053), launched this fund during the financial crisis.
"The best time to find value stocks is in periods of dislocation, such as the global financial crisis, the euro debt crisis and the Trump trade wars," says Mr Sergeant. "[Market dislocation] encourages everyone to pay for Amazon (US:AMZN) but less for economically-cyclical value stocks."
US president Donald Trump's plans for tariffs against Chinese and European imports has sent shock waves through global equity markets and ignited a flight to quality stocks – reliable companies that offer regular revenue and dividends. This has created opportunities for value investors who buy companies of which the share price seems to have fallen below its fundamental value due to poor sentiment or the stage of the economic cycle.
Mr Sergeant's interpretation of value investing involves focusing on potential, valuations and time. He builds a portfolio of stocks he thinks have the potential to provide above-average increases in shareholder value and valuations that could double within three to five years. And he looks to buy these when they are demonstrating a recovery in profits.
Mr Sergeant says doing this enables him to find recovery stocks: established companies that have been through the growth stage and become quality stocks, but entered a period of decline normally due to cyclicality or bad management. Mr Sergeant and his colleagues build positions slowly and if they have reached their potential within five years slowly reduce them.
"The underlying franchise has to be attractive and able to restore shareholder value," he says. "It needs a strong market position where short-term profitability has been depressed but cash flow is starting to improve. It should be clear when you look at the profit and loss account that there's a value gap."
River & Mercantile UK Recovery Fund holds over 200 of these recovery stocks at any one time.
However, while buying opportunities are useful at some point share prices need to rise substantially if you are to make a profit. And this has been a problem for funds that invest via a value style for most of this decade, particularly those focused on UK shares. Over the past five years, MSCI UK Value index has returned 33 per cent against MSCI UK Growth index's 45 per cent. And over the three years to March 2016 before mining stocks, a staple of value indices, rose substantially MSCI UK Value index was down 4 per cent but MSCI UK Growth index rose 20 per cent.
However Mr Sergeant argues that recovery is worth waiting for and says the shares he bought during the 2008 downturn are evidence of this. Within three years of launch in July 2008 the fund had returned 50 per cent against 29 per cent for the FTSE All-Share index. And despite value style investing being out of favour, River Mercantile UK Recovery Fund has returned 41 per cent over the past three years, compared with 31 per cent for both the FTSE All-Share and MSCI UK Value indices. Since launch, the fund has returned 250 per cent – double the return of the FTSE All-Share index.
The UK's economic cycle seems to have stalled due to Brexit uncertainty. "The UK is mid-cycle," says Mr Sergeant. "We started off only a year behind the US which is late cycle, but Brexit has caused a pause. That will be ongoing until there is more clarity on Brexit."
However, when the economy does move into the later part of the cycle value investors are likely to be rewarded. And although market indicators such as government bond yield curves indicate investor caution this looks like it could swing into reverse. "Sentiment will not go much lower than where it is and then economic-sensitive stocks will pick up," adds Mr Sergeant.
An area that could benefit from this is oil services, a sector he says has started to come out of the recovery stage and where profit growth has returned. The oil price has bounced back from its lows of 2016, and after years of consolidation and debt reduction oil majors are making capital investments. This should benefit oil services companies such as Gulf Keystone Petroleum (GKP), the second biggest contributor to the fund's performance In June. Oil and gas companies account for 16.8 per cent of the fund's assets.
But there may be a less positive outlook for other areas popular with value investors, such as mining. This used to be one of River & Mercantile UK Recovery Fund's largest sector exposures, but the FTSE All-Share Mining index has risen 140 per cent since June 2016 so Mr Sergeant took some profits and reduced the fund's allocation to it. And raw material prices have experienced high volatility this summer with the prices of copper and zinc recently hitting lows.
But Mr Sergeant believes there is still room for this sector to run so mining stocks still accounted for 10.4 per cent of the fund at the end of June. He thinks emerging market demand for raw materials still has the potential for significant catch up over the long term. "There won’t be another commodity super-cycle, but there's enough demand," he explains. "Anglo American (AAL), for example, is very undervalued compared with where its mid-cycle profits place it."
Anglo American is one of the fund's 10 largest holdings accounting for 1.6 per cent of assets.
Value investors have to be very careful they don't buy what are known as 'value traps'. These are companies whose share prices are depressed for a reason, for example because there is a problem with them, so they do not revert to the mean.
"And recovery investors need to ask themselves if there are any structural issues in the industry [of the company they are thinking of investing in]," adds Mr Sergeant.
He does not feel this is the case with banks, the fund's largest sector exposure at 24.7 per cent. Banks are held by many value funds, but their share price performance has been disappointing. The FTSE All-Share Banks index has under performed the FTSE All-Share index over one, three and five years, for example, returning 3 per cent over five years compared with 45 per cent for the main index.
"I am still waiting for banks to come through," says Mr Sergeant. "They are in a better place in terms of governance and pay back to shareholders, and their fundamentals are better too. But the valuations remain depressed. I don't really know why – I suppose they do not have the 'jazz' and investors have favoured newer growth stocks."
Hugh Sergeant CV
Hugh Sergeant is chief investment officer of River and Mercantile Asset Management, of which he was a founding partner in 2006. He is also manager of funds including River Mercantile UK Recovery.
Before this he was head of UK equities at Societe Generale Asset Management, which he joined in 2002. He has also worked at UBS Global Asset Management where his positions included head of UK equities, and at Gartmore which he joined in 1987.
Mr Sergeant has a degree in Economics from the London School of Economics.
