For a number of years now, as the New Year approaches equity managers predict that in the following year value style investing will outperform growth style investing. The problem is, this has yet to happen, and value style investing’s underperformance of growth style investing – apart from a short period in 2016 – has been detrimental to the performance of funds run via the former style.
Since the start of 2009 MSCI World Growth index has risen 251 per cent versus MSCI World Value index’s 172 per cent increase. But many value investors such as Alasdair McKinnon, manager of Scottish Investment Trust (SCIN), continue to believe that value will outperform growth over the long term.
Taking this contrarian approach has had mixed results. Since he became manager of this 131-year-old investment trust in July 2014 it has made a share price return of 52 per cent, less than MSCI World index's 62 per cent but more than MSCI World Value index's 49 per cent increase over that period.
Analysts at Winterflood Securities describe the trust as a “work in progress” and believe its underperformance is due to its investment style. They also highlight the trust's 3.2 per cent yield and the opportunity for its discount to net asset value of around 9.5 per cent to narrow, as it is wider than the global investment trust sector average discount of 2.3 per cent. The trust also seeks to control its discount via share buybacks.
So you could argue that all the trust needs is a change in market conditions. But even then it’s the stocks it holds and the price it paid for them that matter. "There are two aspects to value: is it cheap, and is it cheap for a reason or is the market excessively pessimistic?" says Mr McKinnon.
He selects shares via a three-stage process.
“Stage one is looking at if a stock looks cheap using price to book, dividend yield and price to equity," he explains. "But we’re very conscious that there’s an earnings cycle to every company. A stock can look expensive on an earnings basis when its earnings are depressed, so we’re not put off by headline ratios that look incorrect, and take a cycle view of where we think earnings could get to if a company recovers. Then we look at whether the company can survive. The stocks we look at are having a tough time so we check whether it can survive the current downturn in fortunes, and an even bigger downturn or a market shock. We need to be aware of whether the company is in control of its destiny. And then we look at sentiment – what do other people think about this company? If we think something is depressed but everyone else is starting to love it, that puts us off. If everyone is downbeat then it is a bit encouraging, as it implies it won’t take much of a change for people to cheer up.”
“Management behaviour, meanwhile, can be the same as that of any irrational investor in the sense that they could buy high and sell low. You hardly ever see a management team being counter cyclical.”
He then categorises stocks as either:
Ugly ducklings – companies the market hates but he thinks can improve,
Changes afoot – companies where a change in strategy has gone underappreciated by the market, or
More to come – stocks that are no longer ugly ducklings but can grow further for some time.
Following this strategy has resulted in Scottish Investment Trust having about 15 per cent of its assets in retail stocks, despite 2018 being difficult for this sector which has been marred by high-profile failures and a general re-thinking of fashion retailing strategy. The trust's holdings in this area include traditional clothing retailers such as Marks and Spencer (MKS) and US-listed Gap (US:GPS).
Mr McKinnon acknowledges that many retail stocks are not in control of their own destiny but says he focuses on the ones that have taken back control from internet retailers. He argues that physical retailers of consumer staples and fashion should not be written off, because although the online delivery model is convenient for customers it is being subsidised by shareholders and at some point they will realise this.
“Everyone thinks the only way we’re going to shop is on the internet but people like going shopping," he adds. "The big problem with the retailers struggling now is that they over expanded their real estate, particularly between 2000 and 2010, when they should have been thinking out of the box about the internet. But now they’re right-sizing."
He says Marks and Spencer, for example, is a cash-rich company, and is correcting previous mistakes such as wasting capital and being inefficient. “It has a strong balance sheet, owns a lot of its property, has extremely good free cash flow and pays a good yield that is more than covered by the cash flow," he says. “The company has not run out of time and is in control. It can refocus the business for the new retailing era."
But he is perplexed by the nature of growth stocks – particularly tech companies – whose valuations have kept increasing.
“There are companies that grow their revenue but don’t make any money," he says. "Companies valued for billions which are buying each other. If you’ve got an app employing people on bikes on the minimum wage, suddenly you've got a business worth $2bn (£1.58bn)."
