Mind the market shift by paying attention to style drift

So, although value investing has tended to do well historically, it has lagged growth-style investing more recently. MSCI AC World Growth index rose by 243.5 per cent over the 10 years to the end of October 2019, significantly ahead of the 154.3 per cent rise in MSCI AC World Value, in sterling terms. The broader index, MSCI AC World, was up 196.4 per cent over the same period.

Although this dynamic continued for much of 2019, value-style investing has started to do better lately and professional investors have been repositioning their portfolios in the belief that conditions are now looking better for this style of investing. Bank of America Merrill (BAML) Lynch’s latest monthly global fund manager survey reported that professional investors had become much less concerned about the risk of a recession and more optimistic about future corporate earnings. They also tended to have higher inflation expectations.

Many have now moved away from defensive assets including cash, bonds and defensive stocks, shifting into classic value stocks such as banks and energy companies.

Value investors have reasons to be optimistic. A thawing in US/China trade relations could reduce the threat of a recession for the time being. Political moves could boost economies around the world as politicians in several countries, including the US and UK, are considering fiscal stimuli, which could lead to an uptick in growth and inflation. And higher inflation and interest rates can help value stocks.

Many analysts, meanwhile, have thought for a long time that quality and growth stocks appear expensive. The gap in the price and performance of stocks backed by this approach and typical value holdings has now become so large that they have become difficult for some investors to ignore.

Will Dickson, chief investment officer at P1 Investment Management, says: “Particularly over the past year, the movement has been towards value. Some of this may be reversing previous movements towards growth and quality. But from speaking to [fund] managers, it is also likely that the extreme has now become so wide that they are comfortable increasing exposure to value.”

If the tide is turning it would make sense to add more of a value tilt to your portfolio, and this may already have happened via a rotation in some of the funds you hold. However, the strong run enjoyed by growth means that dedicated value managers have become hard to find.

Some value specialists have failed to keep their funds or businesses going in difficult times and others have succumbed to style drift – investing beyond their original remit to keep up with the market. In this case, some managers who claim to focus on value investing have allocated to growth stocks.

Analysis by asset manager RWC Partners from September 2018 suggests that the situation has become extreme in recent years. Although the majority of assets in UK equity funds were run using a blend of growth and value styles, according to the managers running them, analysis suggested most were actually taking a growth approach.

Rachel Winter, associate investment director at Killik & Co, adds that it is important to understand what you are investing in, as demonstrated by the problems with the Woodford Investment Management funds.

“LF Woodford Equity Income Fund (GB00BLRZQB71) was meant to be fairly safe,” she says. “[But it had] a focus on smaller companies, so investors got more risk than they bargained for.”

It is worth looking closely at the style and sector preferences the funds in your portfolio are taking, how the different exposures stack up and whether there is any evidence of style drift – regardless of whether you favour growth or value investing.

But investment style is not everything. Ms Winter points out that many investors “just want funds to go up” in terms of performance. And certain metrics used by many value investors, such as the price/earnings (PE) ratio, may be less informative than they were because many successful technology companies now have intangible assets that can be difficult to price. Now that there is such a gap between different styles and expectations of a shift in market dynamics, it is important that you are aware of how the funds you use are positioned.

Assessing a fund’s style

Not all the metrics that point to how a fund is positioned are easily accessible to private investors, whereas professional investors might observe how a fund’s overall PE ratio compares with that of the market it invests in over time. Dedicated value funds should generally come with a lower PE ratio than their investment universe.

Other details are easier to find, but you may need to watch them closely. An assessment of a fund’s top 10 holdings, which you should be able to find on its monthly factsheet, should give an idea of what its managers are focusing on. The fund's sector allocation, and how this compares with its past approach and the market in which it invests, should also shed some light. For example, if a value fund has moved away from value sectors such as oil and gas, and mining, and moved into technology stocks, this could suggest a change of tack.

Performance figures can also be revealing. “Performance can [display the] traits of value investors,” says Rory Maguire, managing director of fund ratings agency Fundhouse. “They often do well at inflection points in markets and avoid bubbles because of their valuation discipline. They also do well, ordinarily, in the period following a sell-off because they can see an abundance of bargains. So value managers are often defined by a few important periods.”

More recently, committed value investors have been identifiable by “a period of sustained and deep underperformance”, so funds that may not always have appealed could be set to profit from their persistence, if markets turn.

“Every value investor has these scars and they are crucially important to knowing that they will remain true to their process – even in their darkest hour,” adds Mr Maguire.

Data provider Morningstar uses a style box to show, broadly, what areas and approaches a fund is favouring. For example, it shows whether an equity fund has a value or growth style, or a blend of the two, as well as noting whether it focuses more on small, mid or large-cap companies. You can see this on each fund's landing page on Morningstar's website at www.morningstar.co.uk.

Funds with a value approach

Value-style investing has had some false dawns. For example, value stocks performed very strongly in the second half of 2016, so over the whole of this year MSCI AC World Value index rose 34.3 per cent, in sterling terms, versus 23.2 per cent for MSCI AC World Growth index. But this tailed off in 2017, when MSCI AC World Value rose just 8 per cent versus an 18.8 per cent rise for MSCI AC World Growth index.

So if you wish to move your portfolio into value to a certain extent – rather than wholesale – you could add certain funds to your portfolio.

The UK market has been unpopular for some time and includes banks and energy stocks. For UK value exposure, Mr Dickson favours JOHCM UK Dynamic (GB00BDZRJ101) whose manager, Alex Savvides, aims to invest in companies in the process of change where there is the highest probability of success and support in the form of a lower valuation. The fund’s largest holding at the end of October was healthcare company GlaxoSmithKline (GSK).

Investec UK Special Situations Fund's (GB00B1XFJS91) manager, Alastair Mundy, takes a disciplined value approach, aiming to buy companies that are undervalued and on which market sentiment is weak. The fund’s largest sector allocations at the end of October were industrials and financials.

Investors seeking dedicated exposure to specific sectors and investment styles could consider 7IM UK Equity Value (GB00BWBSHV64). This fund's holdings are selected via a quantitative, systematic investment process, which aims to identify profitable, growing companies, assessed as trading below their intrinsic value. It has an ongoing charge of 0.35 per cent so offers dedicated value exposure at a cheaper price than the average active fund, but won't appeal if you prefer a more selective, active approach.

A value orientation can also work well for income investors, because low share prices can mean high yields. But the risk of buying a company that continues to struggle are high, meaning that for this a selective approach is best.

Options include Schroder Income (GB00BDD2DX75), whose managers, Kevin Murphy and Nick Kirrage, look for companies with cash flows, dividends and earnings that have been undervalued by the broader market. The fund had a hefty yield of 5.4 per cent at the end of September.

European equities are another market that has been out of favour and Killik & Co favours Liontrust European Income (GB00BD2WZ329). It says that the fund has offered a higher yield than its underlying market and focuses on companies with more sustainable dividends. The fund had nearly 27 per cent of assets in financials at the end of October.

Another option is a fund that straddles different investment styles but clearly outlines its positioning. Ms Winter favours Monks Investment Trust (MNKS), a global equity fund, because it divides its holdings into four different categories, describing their investment profile.

Performance of suggested funds

Source: FE Analytics, as at 31/10/2019