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Ideas farm: Is Terry Smith a value investor?

Quality and value investing have more in common than first meets the eye
Ideas farm: Is Terry Smith a value investor?
  • Value investing is about buying cheap investments.
  • Quality investing is about buying companies that make cheap investments.
  • The dynamics that create value for shareholders have similarities.
  • Whatever you do, stick with it.
  • Loads of new idea-generating data.

Last week fund manager Terry Smith cautioned investors against being seduced by the “value rotation” and the spectacular performance of beaten-up stocks since November’s vaccine breakthroughs. 

As previously highlighted in this column (Is the value rotation over?, 17 June) the recent outperformance of value, as well as small-caps, is typical in the early stages of a recovery. It also may have already played out, or at least have enjoyed its finest spell.

But for any investors currently focused on quality stocks but itching to jump on the value bandwagon, here’s a thought to help resist temptation: the dynamics of quality and value investing are not actually that dissimilar.

Some explanation is needed. Investment is all about capital allocation. With value investing it is the investor that allocates capital to buy earnings on the cheap in the hope of a rerating. With quality investing it is the company an investor holds shares in that allocates capital to buy earnings on the cheap in the hope of a rerating.

Take the example of a quality company trading on a PE of 20 with a 20 per cent return on invested capital (ROIC). 

First off, what does that ROIC number tell us?  If the business is scalable and returns on investment are fixed, it tells us 20p of new post-tax profit can be bought by the company for every £1 it invests in its business. That’s like picking up shares in the company on a rock-bottom price/earnings (PE) ratio of 5: the maths being P (the £1 invested) divided by E (the 20p annual profit generated from the investment), or 100p/20p = 5. 

The key point is that quality companies allocate capital on very attractive terms. They buy earnings on the cheap.

The new earnings should also rerate, as would be the case with a successful value investment. In fact, in theory the rerating process is far more straightforward. If our quality company retains its PE of 20, when the new earnings materialise they should immediately quadruple in value based on the amount it cost to generate them. 

While in many ways my example is an obscene oversimplification, it hopefully demonstrates that quality investing benefits from many of the same dynamics as value investing. On a more prosaic and probably more important level, though, it's another reason to resist the temptation to flip-flop based on ever-changeable stock market trends. There’s nothing wrong with altering one's views and investment approach, but it is very dangerous to do so simply to chase the latest hot thing.

The most reliable way to invest well is to find an approach that is both sensible and resonates on a personal basis. Then stick with it unless there is a very good and well-understood reason not to. 

Process, consistency and patience are the foundation on which the investment alchemy of compounding works. Having the humility to adopt sensible diversification is also important to building a portfolio that can survive downturns and support one's resolve.

Read the Investors Chronicle’s 3 Cardinal Rules of Investing here