Did you get the memo? Value’s dead. Over recent years, an increasing number of investors seem to have come to this conclusion. The Covid-19 crisis has provided yet another reason to think value investing is the preserve of losers.
A classic value style has performed terribly for a decade and since the start of the year to the end of April the MSCI World Value index was off 20.2 per cent compared with a negative 4.3 per cent of MSCI World Growth. The dire result from my Late Bloomers value screen that I ran 12 months ago seems to be just another ghoul dancing on value’s grave (see table).
LATE BLOOMERS 12-MONTH PERFORMANCE
|Name||TIDM||Total return (23 May 2019 - 8 May 2020)|
|LSL Property Services||LSL||-24%|
|Gem Diamonds (Di)||GEMD||-59%|
Source: Thomson Datastream
But when it comes to the question of investment styles, this column is agnostic. As such, my screens will not be laying 'value' to rest. After all, prior to the credit crunch it was a phenomenally successful investment approach. Indeed, lest we forget, if we dial back the clock a decade, it was value investing that made growth investing look like the preserve of losers. Given how fickle and unpredictable market trends are, I think the value screens monitored by this column are worth sticking with especially at a time of change as we are experiencing now. The caveat here is I have no idea when the fortunes of value investors may turn. Indeed, there are several reasons to think it may not necessarily be soon.
The term 'value' is applied to many different strategies, including the Buffett-esque approach of paying up for companies that offer the magic combination of quality and growth. Indeed, buying a stock that does not appear to offer any value should be off the agenda for any sensible long-term investor. So, in some sense, any investing, aside from short-term trading and trend following, is value investing.
Semantics aside, in this column I take the more prosaic view that value investing involves buying shares that have a low valuation attached to them compared with either the market as a whole, their sector, or their own valuation history. This is more akin to what Mr Buffett described as cigar-butt investing; an approach he employed early in his career. The term Mr Buffett coined was based on the idea of a cigar butt discarded by a smoker (the previous owner of a share) while still offering an avid ash-tray surfer one last puff for free – value investing is often distasteful and grubby!
Perhaps it is telling that Mr Buffett eventually rejected his cigar-butts in favour of investing in companies that generate high returns on investment and have the potential to invest more in growth (compounders). Star manager Nick Train describes the evolution of his own highly successful investment style along similar lines to Mr Buffett kicking his cigar-butt habit.
There are two key ideas behind a buy-the-cheap-stuff/cigar-butt value investment approach. One is that sentiment can become so poor towards shares in a troubled company that the price can fall a long way below intrinsic (true) value. In this case, the value investor believes fundamentals will prevail, possibly as a result of corporate action. The other idea, which is similar in some ways, is based on 'reversion to mean'. That’s to say that, over the long run, valuation moves towards the long-term average. So if a valuation is well below this average, value investors would hope for an upward rerating over time as sentiment improves; probably as a result of depressed trading reverting to the mean.
Hardcore advocates of reversion to the mean see pretty much all valuations, growth rates, margins and returns on capital finding similar levels over the very long run. This idea feels very removed in the context of today’s global markets, which are dominated by a handful of huge and massively successful companies, which seem to promise ongoing high returns and high growth.
The success of a few large companies is often given as one of the big problems value investors have faced over the past decade. Companies such as Google parent Alphabet, Facebook, Microsoft and Amazon seem to have near monopolistic power, which allows them to comprehensively outcompete rivals while offering goods and services that consumers and businesses want more and more of. These companies both disrupt other industries – such as retail, print media and increasingly real estate – either directly or indirectly by providing technological tools to other disruptors. This provides a major challenge for incumbents in certain industries and means they may well never again be as profitable as they historically were. The discovery of new superior business models in old established industries has increased the proportion of 'value plays' that turn out to be 'value traps' – companies that look cheap because they are in terrible trouble that is not going to abate.
Value has another big problem. The easy money that started to flood the system after the credit crunch has kept many struggling companies alive for longer than would otherwise be the case. In order for companies in troubled industries to see trading revert to mean, a vital ingredient is normally the failure of weaker rivals. When rivals go out of business, supply falls, which helps it get back into equilibrium with demand. Often supply will end up significantly undershooting demand before new competitors and investment are finally attracted back into the industry. The overshooting of supply and of valuations in both directions can provide a bumper ride for the value investor. But easy money keeps weak companies going and thereby undermines this dynamic. Indeed, value as a style has performed well over the last 10 years during brief periods when it has looked like the interest cycle may be set for a sustained turn upwards.
If industry disruption and easy money are the causes of value’s plight, they do not look as though they will disappear any time soon. In fact, the Corona crisis has accelerated the disruption trend and caused central banks to further massively loosen monetary policy.
However, there are some reasons for optimism for value enthusiasts – the darkest hour is just before dawn, and all that. For one thing, many traditional preserves of 'value' are indeed very cheap. Banks are trading well below tangible net asset value and oil companies can be bought on a low-single-digit multiple of historic earnings. Recent research by quant firm AQR suggests that, on some measures, the gulf between the valuation of the market’s most expensive and cheapest shares is at the highest level in their half-century monitoring period.
From a more piecemeal perspective, some recent screens have also highlighted very cheap looking shares in companies that, while not wonderful quality plays, nevertheless look like they could get through the current crisis and have businesses producing a decent profit on the other side.
There are also at least two potential catalysts that could cause a reassessment of value, although there is no certainty either will play out either quickly or at all. Firstly, there is the question of how the market will react to the huge issuance of government debt to support and revive corona-hit economies. Should investors prove reticent about funding all this borrowing, the interest rates offered by government bonds may have to rise, which could play into value’s hands. Interestingly, there has been very muted reaction from bond prices to the Fed’s multi-trillion dollar bond buying programme – although bond yields were already on the floor.
Higher interest rates would potentially be a boost for value because it will cause investors to put a lower value on the future earnings of companies (because of something known as the discount rate), and growth companies whose valuations are more dependent on their future earnings have most to lose from such a shift.
Secondly, there is the question of how society will react to what amounts to a massive corporate bailout. Following the banking bailout 10 years ago there was a considerable backlash. Prior to the coronavirus bailout, many high-profile politicians, especially in the US, had been expressing significant unhappiness about the level of share buybacks by publicly listed companies. Among the criticisms are that buybacks help companies avoid tax (interest paid on loans taken out to fund buybacks is not taxed) and help executives earn bonuses based on EPS growth at the expense of other key stakeholders – such as employees. The fact that many of these same companies now find themselves short of cash and asking for taxpayer help could prompt calls for redress. Almost by definition, the burden of any corporate tax rises – and possibly other regulation – will fall on the most profitable companies. This is something that could improve the case for less profitable 'value' plays.
THE INCONVENIENT TRUTH
Musings aside, the hard fact is the value style has done very poorly over many years and the past 12 months. While my Late Bloomers screen has had some strong years since I began to monitor it in 2014, overall the results have been poor, with a cumulative negative total return of 5.8 per cent compared with a positive 8.7 per cent from the FTSE All-Share index. This gets even worse when I inject a sense of reality into the figures by applying an annual charge to represent dealing costs (the screens in this column are seen as a source of ideas for further research rather than off-the-shelf portfolios). With a 1.5 per cent annual charge the six-year cumulative total return drops to a negative 13.9 per cent.
The screen itself looks for shares that appear to be cheap against their long-term history. Because earnings can fluctuate wildly over the course of an economic cycle, especially in the kind of companies that stand out as 'value' plays, the screen looks at a valuation based on the source of a company’s earnings. For most companies the source of earnings is taken to be sales, but for more asset-focused businesses, such as banks and real estate, the source of earnings is considered to be net asset value (NAV) – also known as book value (BV) or shareholder equity.
The screen’s other key focus is to look for companies that have been more profitable in the past – ie, an indicator that if a reversion to mean happens, it will be positive for profits as well as valuation. There are also some tests to see if a company looks like it is in a viable financial position. The full criteria are:
■ Value: ZEUS ratio of -1 or less. While I have given this ratio a snazzy name, the idea is quite simple. It measures where a valuation lies within its 12-year range (a minimum range of three years is allowed for companies without a long enough history). The ratio uses a standardised stats measure called the Z-Score. This starts to really suggest a stock is cheap compared with its history at -1 (roughly in the bottom 17 per cent of the range) and extremely cheap at -2 (roughly in the bottom 2 per cent). As already alluded to, if a company’s prospects are never going to revert back up to the long-term average, then the apparent cheapness may well be a value trap.
■ Recovery potential: Real estate companies get a free pass on this test. For financials, return on equity needs to be at least one-third below its 10-year peak. For other sectors, operating margin at least a third below 10-year peak.
■ Balance sheet: For financials, equity representing at least 5 per cent of assets and return on assets of at least 1 per cent. This is a test suggested by the great Peter Lynch, the former star manager of Fidelity’s flagship Magellan fund. For utilities, which have very defensive earnings streams well suited to supporting high levels of debt, net debt to book value (gearing) of less than 150 per cent. For real estate companies, gearing of 75 per cent or less. For housebuilders, gearing of 25 per cent or less. For all other sectors, net debt of 1.5 times cash profits or less.
■ Growth: Growth in 'earnings ultimate source' (the EUS in the ZEUS ratio). Depending on sector, either sales or book value must have risen over the past 12 months. Book value for financials, real estate and housebuilders and sales for all other sectors.
■ Positive free cash flow: Free pass for financials and real estate
(NB investment trusts are excluded from this screen but not Reits)
This year 19 stocks passed all the screens tests. Details are in the accompanying table.
|Name||TIDM||Sector||Mkt cap||Price||Fwd NTM PE||DY||PSR||P/BV||Fwd EPS grth FY+1||Fwd EPS grth FY+2||3-mth fwd EPS change||3-month momentum||Net cash/ debt (-)|
|Anglo American||LSE:AAL||Diversified Metals and Mining||£17bn||1,354p||9||6.1%||0.8||0.9||-33.2%||33.2%||-33.3%||-32.8%||-$4.4bn|
|3i||LSE:III||Asset Management and Custody Banks||£7.3bn||756p||-||5.0%||5.3||0.9||-||-||-||-33.2%||-£32m|
|Hargreaves Lansdown||LSE:HL.||Asset Management and Custody Banks||£6.9bn||1,450p||28||2.4%||14||16||6.0%||-12.8%||-14.9%||-15.9%||£299m|
|Fresnillo||LSE:FRES||Precious Metals and Minerals||£5.1bn||689p||34||1.6%||3.2||2.1||9.4%||85.3%||-19.9%||3.2%||-$477m|
|Standard Life Aberdeen||LSE:SLA||Asset Management and Custody Banks||£4.8bn||217p||16||9.9%||1.3||0.8||-28.5%||8.5%||-26.8%||-30.7%||£370m|
|Ashmore||LSE:ASHM||Asset Management and Custody Banks||£2.5bn||370p||15||4.6%||7.5||3.1||-0.3%||-6.2%||-||-34.6%||£684m|
|Hays||LSE:HAS||Human Resource and Employment Services||£1.8bn||105p||23||3.8%||0.2||2.5||-62.2%||-34.0%||-||-38.0%||-£215m|
|Rathbone Brothers||LSE:RAT||Asset Management and Custody Banks||£780m||1,442p||15||4.9%||2.0||1.6||-23.4%||2.7%||-26.3%||-28.3%||-£5m|
|CLS||LSE:CLI||Real Estate Operating Companies||£754m||185p||17||4.0%||5.4||0.6||-8.6%||11.7%||-15.7%||-30.9%||-£636m|
|Playtech||LSE:PTEC||Casinos and Gaming||£705m||237p||14||2.2%||0.6||0.7||-56.3%||125.8%||-62.6%||-35.6%||-€355m|
|NCC||LSE:NCC||IT Consulting and Other Services||£446m||160p||28||2.9%||1.7||2.2||-38.7%||-5.1%||-48.1%||-30.9%||-£51m|
|Picton Property Income||LSE:PCTN||Diversified REITs||£363m||67p||16||5.3%||7.7||0.7||-10.7%||10.7%||-||-32.0%||-£169m|
|Hunting||LSE:HTG||Oil and Gas Equipment and Services||£286m||175p||12||3.5%||0.4||0.3||-58.5%||29.0%||-53.2%||-45.8%||$78m|
|Standard Life Investments Property Income||LSE:SLI||Diversified REITs||£280m||69p||-||6.9%||8.4||0.8||-||-||-||-26.2%||-£120m|
|Real Estate Credit Investments||LSE:RECI||Thrifts and Mortgage Finance||£233m||102p||9||11.8%||5.9||0.6||-7.4%||5.7%||-1.5%||-40.6%||-£14m|
|Topps Tiles||LSE:TPT||Home Improvement Retail||£72m||37p||66||9.2%||0.3||2.4||-91.6%||103.9%||-90.4%||-51.9%||-£11m|