Welcome to value hell

Value investing has been doing very badly for a long time but lockdown has dealt the investment style a fresh and powerful blow. My ZEUS stock screen is probably the most unadulterated 'value' screen run on these pages as it has a very basic focus on valuation and the concept of “reversion to mean”. It really took both barrels from the value melt-down.

The performance over the past 12 months has been extraordinarily bad. Indeed, if there is a positive to be taken from the performance, it is that it provides a visceral illustration of just what a fraught year it has been for investors that like to buy the cheap stuff.

And to really revel in the ghastliness of this screen’s 2019 stock picks we need to look at the really cheap stuff; the top five picks out of the 50. In previous years these have been a bright spot for what on the whole has been an unimpressive screen. However, in the last twelve months the light definitely went out.

Between them, these shares managed to deliver a negative total return of almost 70 per cent. That is quite a stunning achievement, in a bad way. The best performance of the five was a 57 per cent drop from building and regeneration company U & I. Meanwhile, against stiff competition the stock to lose most value was Capita which plunged an epic 85 per cent. That said, shares in car dealer Lookers have been suspended since July as it struggles to prepare its accounts after uncovering fraud at the business. Better than expected third-quarter numbers provide a sliver of hope. 

12-MONTH PERFORMANCE

Source: Thomson Datastream

The trouble for these companies is that the apparent 'value' on offer 12 months ago was a reflection of their vulnerability. What was needed was a bit of good fortune for any upside to be realised. What these businesses got instead was a pandemic heaping more problems onto their troubled operations. The severity of the situation is reflected in the fact that for the top five shares, while the market has rebounded a bit from its March lows, these shares have collectively gone on to plumb new depths. 

The bigger versions of the screen have fared better but the performance is still substantially worse than that of the index. Over the three years I have followed this screen it has produced a negative total return of 19.3 per cent compared with 10.7 per cent from the FTSE All-Share. The top five meanwhile are down 64.3 per cent in that time.

Crash test dummy

One lesson to come out of observing the carnage is that looking at valuation without taking much else into account can be a dangerous business. Indeed, this screen was principally set up to showcase the ideas behind the ratio at its heart (see below). The unrefined approach means that even more than is normally the case, results of this particular screen need to be married with further research. Indeed, the only additional criteria used to try to eliminate the inevitable value traps is three-month momentum. 

The valuation criteria that takes centre stage for this screen aims to capture the idea of “mean reversion”, which is a key tenant for traditional value investors. The principle is based on the idea that businesses have a long-term run rate that they ultimately return to. Value investors apply the concept of mean reversion to share-ratings moving back towards the long-term average as well as the profitability of businesses moving towards a long-term average. 

The major danger in applying this concept to investing is that sometimes situations change permanently, and there are grounds to believe the pace of technological change now being experienced means disruptive trends will be more prevalent than in the past. The other issue with mean reversion is that companies that are poorly managed or overly indebted may never get the chance to reclaim past glories.

Critiques aside, to capture both key mean-reversion ideas (share rating and business profitability), the valuation measure used by this screen looks at how a company is being priced relative to the source of its earnings and how that rating compares with the long term history. 

The idea here is that by focusing on the source of a company’s earnings – either sales or net asset value depending on the company – investors will not be distracted by temporary swings in profitability that show up when using valuations derived from earnings. Indeed, for anyone who believes in reversion to the mean, companies making very low profits compared with history or even losses are considered potential opportunities.

Meanwhile comparing valuation with the long-term history suggests the possibility of a re-rating. A standardised statistical measure called a Z-score is used to make the comparisons with history. The comparison aims to cover 12 years to capture a full economic cycle but if there is not data covering such a long period, a minimum of six years is used. A Z-score (the standard divisions from the average) can be considered as low (potentially “cheap”) at -1 and extremely low at -2 or below.

Because the screen uses a Z-score based on a company’s Earnings Ultimate Source, I managed to give the measure the shamelessly -ortured acronym ZEUS. The screen simply combines a ranking of shares by this ratio and three-month momentum to get a list of the highest ranking 50 shares which can be found again.

Loser

After last year’s screen performance the question with running this screen again is; why bother? It is true, this is not a very good screen and more an experiment with looking at a valuation ratio and traditional “value” investing principles. However, it does provide a lot of ideas to be shifted through, and as far as value investing goes, writing off an investment style that was so successful prior to the credit crunch seems a bit rash.

Indeed, there are those who still dare to present the case for value, and their arguments are not without foundation. Key themes are the extent to which valuations between growth stocks and value plays have diverged, and the fact that there seems limited room for a continuation of the 40 year long fall in bond yields. Falling bond yields in theory provide a reason to put a higher rating to growth stocks. That said, these arguments in favour of a value resurgence were popular even before the recent sell off. Indeed, they have been popular for many years now, and to no avail so far. The argument that seems to have died since the March crash is the assertion that value will outperform in a downturn. No prizes for guessing why this is no longer being widely touted!

50 CHEAP SHARES

Source: FactSet