Price is what you pay, value is what you get

Posted by Liz Rees in Weekly musings category on 08 Nov 18

The above is the philosophy of legendary investor Warren Buffett, aka the Sage of Omaha. His investing success, based on adoption of the value style of investing, has made him the third wealthiest man in the world and, at 88 years young, he remains CEO of Berkshire Hathaway, a leading constituent of the S&P 500.

Buffett contends that price and value are not always the same. The fundamental value of a business stays within a narrower range than the share price which can fluctuate much more widely with sentiment. What he means is that share prices can detach from reality but value measures present a truer picture of a company’s worth.

Last week I highlighted the relatively low valuation of the UK market. One reason why the UK looks cheap at present is its higher exposure to value sectors, in particular financials and resources, and correspondingly low representation in technology, compared with most other developed markets.

That said, value has underperformed over the last decade with the MSCI World Value index up 179% over 10 years to 5th November 2018 compared with a far more impressive 260% advance in the MSCI World Growth index. That leaves value stocks at their largest discount to growth stocks in over 40 years.

Why has growth done so well? The explanation may be the below average growth rates during the protracted recovery from the financial crisis. When growth is scarce investors are prepared to pay a higher price for growth stocks. But measures such as US fiscal stimulus and a winding down of austerity measures could give a boost to the global economy (clearly this could be countered by trade wars) and this would promote the case for value stocks.

So could we be at a turning point? The MSCI UK value and growth indices have been neck and neck this year (both down just over 4%) even though globally, growth still leads the way. However, in the October sell-off value stocks held up significantly better in most regions. Admittedly there have been false dawns before, notably in 2016, but it is worth a recap of the features of a value approach.

The criteria used vary between individual Fund Managers but, in essence, value investors hunt out companies which they consider cheap or undervalued. These managers are contrarians, going against the crowds. They look for buying opportunities when others are selling.

Companies with low PE (price/earnings) ratios may be found in out of favour cyclical sectors, for example mining, housebuilders or retail. Their fortunes depend on the health of the wider economy so profits can be lumpy. Alternatively, a business with a low share price relative to book value may have depressed earnings or dividend yield but could benefit from a catalyst for improvement, for example new management. A more conservative approach involves targeting high yielding stocks offering maintained or increasing dividends; many income fund strategies adopt this approach.

In contrast, growth investors focus on companies with above-average growth prospects. These stocks command a high PE which can often reflect a momentum effect as enthusiastic investors chase them higher. What has kept growth stocks on the front foot in recent years is that they have persistently beaten earnings forecasts, preventing the PE from expanding too far. Of course, if the party stops there could be a lot of momentum investors jumping ship.

Certainly, missed targets are harshly punished. Recent sharp falls across the board in technology stocks, on the back of a few slightly disappointing numbers, implies that investors may not be wedded to growth stocks in the way they once were. Whether this is a blip or the start of a trend is hard to say as buyers did emerge at the low points.

What else might help value to have its day again? Donald Trump’s pro-growth and ‘reflationary’ policies have contributed to upgrades of global growth and inflation. This would be expected to translate into improved corporate earnings growth and increased appetite for risk which favours economically sensitive value stocks. For example, commodities benefit from stronger growth; energy companies from higher inflation and banks from higher interest rates.

Turning back to the UK market, Schroders offers funds with a deep value style: both their Recovery Fund and Income Fund are run by the same team along the same principles and have a large cap focus. Fidelity Special Situations, managed by Alex Wright, searches for opportunities across the entire market cap spectrum so will include out of favour domestic plays.

Some funds have a blended approach (less than 10% of UK funds adopt a true value style) which means they tilt towards one style at different times. This can help smooth returns as a particular style can be in or out of favour for a lengthy period of time. A good example of such a fund is Artemis Global Income which is currently finding a record number of special situations offering good value.

Whatever, your preference, there will always be exceptional growth investors and exceptional value investors, so picking the right manager is just as important as the style bias.

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