I know I bang on about this, but value investing is about so much more than buying low price-to-earnings or low price-to-book stocks. True, this is how so-called value factor indices that have been introduced in recent years by index providers such as MSCI and Russell are constructed, but buying funds that track these indices is not value investing. Value investing has its origins in the 1930s and it is a lot more sophisticated than looking at basic valuation ratios.
The core principle of value investing is to buy things well below their intrinsic value. This can apply not only to the equities of companies but also to individual bonds and other types of investment, as well as asset allocation. There are ways of assessing the intrinsic value of, say the US treasury market as a whole, as there are ways of assessing the intrinsic value of Marks and Spencer. The principle could even be applied to grocery shopping, though I’m open to suggestion as how one would calculate the intrinsic value of a banana!
We at Seneca are multi-asset specialists and applying the aforementioned principle of value investing to the entire spectrum of our active decisions is exactly what we seek to do. We call our framework Multi-Asset Value Investing, or MAVI for short.
In this second article in my quarterly blog series about value investing, I thought I’d consider some of the challenges that investors are facing at the moment and how we are using MAVI to tackle them.
The biggest challenge that we as investors all face is the impending end of the bond bull market that began, at least for much of the developed world, in the early 1980s. Since then, real returns from safe haven bonds have been in the order of 8 per cent per annum, so sticking a large part of a balanced portfolio in them has worked just fine.
With real yields at both ends of the curve now either low or negative, and inflation low and thus less likely to fall further, the prospects for bonds over the medium to long term are dim. Indeed, if you buy the 2068 inflation-linked gilt today and hold it to maturity you are guaranteed to lose 57.9 per cent of your real capital. Since real yields are negative and inflation is more likely to rise than fall, it’s not hard to see that bonds are trading at a huge premium to intrinsic value.
In this sort of world, you’ll need to find a substitute for what has in recent decades been a very reliable source of returns in a balanced portfolio.
Equities can take some of the strain, because equities don’t necessarily perform poorly during bond bear markets. In the last bond bear market in the US from 1940 to 1981 (during which bonds returned -2.7 per cent per annum in real terms), US equities actually returned +5.9 per cent per annum in real terms. One way of interpreting this is that equities are less risky than bonds, which may come as a surprise to many.
Nevertheless, you still wouldn’t want to own an equity-heavy portfolio, given equities’ tendency to be volatile in the shorter term if not the longer term; a big drawdown in markets like the one in 2008/9 could be terminally damaging, particularly if you were already in retirement.
At Seneca, we have a number of solutions to this predicament.
Starting with the conceptual framework of a basic 40/60 equity/bond (E/B) balanced fund, we put 25 per cent into what we call specialist assets (SA). For a more defensive fund, we suggest a 40/35/25 E/B/SA mix and for a more growth-oriented fund we suggest 60/15/25. In both cases, the 25 per cent going to specialist assets is being ‘funded’ from the bond segment, with the bond segment also funding a 20 per cent increase in equities in the growth-oriented fund.
So, what are specialist assets?
On the whole, they are London-listed investment trusts that invest directly in tangible assets such as property (REITs), infrastructure (including renewable energy infrastructure), airplanes (aircraft leasing) or intangible assets such as direct lending platforms or reinsurance contracts.
They do not have some of the characteristics of bonds, but nor do they have some of the characteristics of equities.
In relation to bonds, they tend to have decent yields in the order of 5-10 per cent, and income streams that are index linked (a REIT’s rental reversions for example will tend to be linked either explicitly or implicitly to CPI or RPI).
In relation to equities, they tend to have income streams that are more stable. Corporate profits will tend to fall in a recession because of operational and financial gearing, something that does not affect our specialist assets, at least not nearly to the same extent.
True, discounts of investment trusts may widen in an equity bear market, but we do not believe this to be an important risk to be avoided at all costs. Yes, you may see the market value of the trusts go down, but if the underlying income streams are stable, this ‘loss’ will be temporary, not permanent.
How do we apply MAVI in relation to specialist assets? Simple. If you know the yield and can assess future income streams, you can calculate intrinsic value.
What else can we do to protect investors from the looming bond bear market?
Well, there are three other parts of our portfolios in which we are seeking to add value through active management decisions: UK equity selection, fund selection in overseas equities and fixed income, and tactical asset allocation.
Within the UK, we focus on mid-caps, which tend over time to perform better than large-caps; they’re smaller so have more scope to grow. We also have a high conviction approach, which tends to produce better performance. As far as MAVI is concerned, we apply the more traditional aspects of value investing as set out in Graham and Dodd.
As for fund selection within overseas equities and fixed income, we again have a high conviction approach (small number of funds), but look for managers who themselves have a value investing style (the equivalent in fixed income is called relative value) whether explicit or implicit.
As for tactical asset allocation, we are looking to overweight asset classes and markets whose yields are higher than we think they should be and thus which should perform well over the next 3-5 years. Similarly, we try to underweight or avoid yields, the aforementioned safe haven bonds being a good example, that are lower than we think they should be.
So, you see that there is plenty you can do to navigate your way through the coming turbulent years and generate decent returns. You just need to know where to look.
Peter Elston is chief investment officer of Seneca Investment Managers. The views expressed above are his own and should not be taken as investment advice.