Value investing has a lengthy pedigree. Benjamin Graham, the architect of the approach, wrote The Intelligent Investor back in 1949 and it remains the foundation stone of many value investing strategies today.
At its heart, value investing aims to cut through speculation about a company’s prospects to look hard at the reality of the business and buy its shares if they are trading at a discount to their intrinsic worth. There are, though, plenty of variations on this theme.
Graham’s book argues that buying the cheapest stocks – as indicated by a range of valuation metrics, such as ‘price to book’ and ‘price to earnings’ – will lead to better performance over the longer term.
Many of the ‘purest’ value investors still work this way, with one of them, Schroder Global Recovery co-manager Simon Adler, explaining: “We take an academic definition of value, which looks at elements such as share price to 10-year average earnings or share price to next year’s earnings and dividends, plus share price to cyclically adjusted earnings.”
Price rather than growth as the biggest driver of returns
Value investing starts with the premise the price you pay – not the growth you see – is the biggest driver of future returns. To put it another way, a company growing at 10% could be a great investment if you buy in at a low price; in contrast, one growing at 100% could be a terrible investment if you overpay.
At the same time, it is important to look at a company as objectively as possible. “Some investors will try to forecast how a company will perform over the next five years,” says Kevin Murphy (pictured), co-head of the Value Investment team at Schroders. “In our view, however, trying to predict what will happen in the future is nothing more than a guess. It can lead to problems – if the global financial crisis, Brexit and Covid-19 have taught us anything, it is that human beings are terrible at forecasting.
“Our starting point is that we do not know what the future holds. We want to know what a company has already done, the profits it has already shown it can make. This is an old-fashioned value discipline as espoused by Benjamin Graham.” Of all investment approaches, argues Murphy, this one has withstood the greatest amount of academic scrutiny over the longest period of time.
Value investing involves looking at businesses closely and understanding where they draw their revenues and profits. For Royal Mail, for example, it may be about getting past the long-held view that it is all about sending letters, as this overlooks its vast parcels operation.
Why value investing goes against human nature
A major psychological hurdle for followers of a value approach is it tends to lead them towards unappealing and unloved companies and sectors. “Value investors are looking for companies that are cheap and out of favour,” explains Fundcalibre managing director Darius McDermott. “It could be a good business that has gone through a short-term change that has affected the way the market looks at it but there is a ‘contrarian’ element, too. Value investors are looking at those parts of the market others are not.”
“This is tough,” adds Dan Brocklebank, UK director at Orbis Investments. “It goes against human nature as people are much more comfortable receiving approval as part of a crowd.” It also means value investing is periodically subject to the view that its time has passed.
Today, for example, says Brocklebank, one of the reasons investors are concerned that value investing is ‘dead’ is because the traditional price-to-book valuation multiple is arguably obsolete in a more knowledge-based economy. “It is vital to remember that multiples are only ever a short cut to estimating the intrinsic value of companies,” he adds, however.
“The fact that accounting book value is increasingly irrelevant for swathes of the economy does not mean valuations do not matter in investing. Multiples can sometimes provide a helpful indicator of true cheapness. Using fundamental research, and good judgement, to identify companies trading for less than the net present value of their future cashflows is, however, what it really means to be a value investor.
“If you look at it another way, ‘growth’ and ‘momentum’ strategies have been so successful in recent years that the expectations embedded in valuations in some parts of the market have become extraordinarily stretched. With the market so lopsided, aggregate valuations so high and people so willing to proclaim the ‘death of value’, ensuring you have solid valuation support in your portfolio is more important than ever.”
Avoiding value traps as sectors face disruption
Much of value investing is about avoiding so-called ‘value traps’ – businesses that are trading cheaply but for a good reason. Debenhams might be a topical example.
“Value investors always need to be alert to companies that are cheap for a reason – for example, where businesses get into trouble because they have too much debt on their balance sheets or because they are disrupted,” explains McDermott. “They need to watch out for sectors in terminal decline.”
The idea that businesses and sectors can be disrupted by new technologies or management techniques, say, remains a loaded question for value managers – and Schroders’ Murphy strongly disagrees we are seeing more disruption today than in previous eras. “Disruption is happening all the time,” he says. “It happened with canals and railroads. It is nothing new. Value as a concept has been through many cycles.”
Brocklebank agrees, noting: “Disruption is always happening – it is just that people tend to extrapolate more than is actually happening today while forgetting major disruption has happened repeatedly in the past.”
That is not to say value investors can ignore present instances of disruption. “There will be plenty of stocks that are deceptively cheap, where the business is under real pressure,” says Murphy. “The problem is that investors can see disruption like kids see monsters under the bed.”
His colleague Adler adds that research continually suggests expensive stocks do not grow as much as investors think while cheap stocks do not tend to fare as badly as the wider market currently believes.
Value investing isn’t all about banking, basic materials and traditional retailing
Equally, investors should not accept the view that value is all about investing in ‘old economy’ areas such as banking, basic materials and traditional retailing, as a value portfolio may look very different at different points in the market cycle.
“If you do this job for long enough, you will see all companies at all prices,” says Adler. “Until relatively recently pharmaceuticals were very cheap, while banks were very expensive. We have owned Microsoft in the Global Recovery Fund. What is cheap will look quite different at different times.” As a result, value investors have to be capable of analysing different types of company and they need to remain flexible.
“Tesco’s was a growth stock in the noughties,” says McDermott. “It was growing globally in India, Thailand and the US. Then, it was hit by the rise of the budget supermarkets, it lost market share, there were some accounting irregularities, its overseas ventures failed. So it has been a growth stock and a value stock.”
What are the different types of value fund?
Naturally enough, then, there will be differences in approach between value managers.
Ian Lance, manager of the RWC Income Opportunities Fund, says: “We would draw a distinction between intrinsic value investing or sustainable value investing – when you are trying to buy a business where earnings and intrinsic value will grow over time – and deep value or recovery investing, where you are buying something that could be in decline or teetering on the edge of insolvency but you still think you can make money out of it. This is sometimes called ‘cigar butt’ investing.
“Value is created when overreaction and extrapolation cause investors to sell stocks that are clearly trading for less than they are worth. In 2020, this has been caused by fears of an economic downturn and hence cyclicals have become cheap. This would cover areas such as financials, energy, materials, industrials, retailers and so on.”
Taking Amazon as an example, the key question is not whether it will succeed, but whether it will obliterate every other retailer – because, at 130x earnings, that is the way it is currently priced. It may be worth remembering that, back in 2000, everyone wanted to own technology and no one wanted to own tobacco – yet expectations were so low for the tobacco companies they proved to be a good investment over the next decade. “Cheap companies only need to surprise slightly on the upside,” notes Adler.
One final question is where value fits in the context of responsible investing. With environmental, social and governance (ESG) principles very much at the top of investors’ agenda, intuitively it would seem the unfashionable sectors in which value managers tend to fish would be off-limits.
Adler disagrees, arguing he can find plenty of ESG leaders among the companies in which he invests. Even so, it is perhaps best to describe this as a ‘work in progress’ for value managers.
Over the decade or so since the global financial crisis, value has experienced a prolonged period in the wilderness but it is an approach that has confounded expectations time and again to show its worth over the very long term. At the moment, it may be struggling against the perception of a world in disruption but history suggests its moment will come again.
This article first appeared in The Professionals’ Guide to Value Investing. Click here to read more.
