As rising inflation expectations push value stocks back under the spotlight, investors who shunned this strategy in the growth bull run are returning in their droves.
However, value investing is not as easy as picking up battered stocks on lowly P/E ratings and waiting for them to bounce back to their previous share prices. Many of these are cheap for a reason and are just as likely to fall further than to rebound to their previous level, even in a recovery.
Source: Momentum
The ability to avoid these value traps is a key consideration for Gary Moglione and the team behind the Momentum Multi-Asset Value Trust, formerly Seneca Global Income & Growth, and their success in this regard is one of the reasons why they have managed to outperform over the past 10 years even though their value style has been out of favour.
Here, Moglione reveals his three-step process for avoiding stocks that are destined to stay cheap forever.
Take a glass half-empty approach
The team of managers and analysts on the Momentum Multi-Asset Value Trust do not dismiss entire industries out of hand, even if they are being severely disrupted. However, Moglione said that in such situations, you need to hope for the best but prepare for the worst.
Analysis of an individual company begins with building an EVA (economic value added, or profit minus the full cost of capital) model, which is then compared to the company’s return on invested capital. Moglione said the important part of this approach when dealing with potential value traps is the assumptions you use.
“If we're doing a normal base case, you may use management guidance and talk to the market in terms of what its growth rates are, whether that is in subscriptions, whether that is in sales and so on.
“What we tend to do is build in quite conservative or negative assumptions. Whatever management is guiding, what we will actually feed into the model gives you a natural margin of safety.
“This means the business can underperform relative to what estimates the management is going on, and you've still got a protective buffer.”
Balance the books
Moglione said scrutinising company balance sheets is vital because this is where the vast majority of value traps have been exposed in the past, usually on the debt side. The economic shutdown of last year highlighted the importance of this step.
“You had a bad turn in markets where businesses that were functioning normally and excelling and growing over the years pre-Covid suddenly had their market shut down,” he said.
“Straight away, the key test was, is their balance sheet strong enough?
“One of the projects we did last March was ask, what if the downturn was continuous from March to the end of the year? What is the debt level, what are the covenants on the debt and will it breach? Because that will ultimately result in impaired capital.”
Find out why you’re wrong
Investors are often warned about the perils of confirmation bias, where they subconsciously filter out information that disproves their hypothesis and focus instead on anything that supports it.
To prevent this from happening on the Momentum Multi-Asset Value Trust, once an analyst has found a stock idea that has passed the two hurdles mentioned above, they will present the investment case to the rest of the team and invite them to pick holes in it.
“We're not going to be challenging as confidently on the valuation side because we haven't done as much in that way as the analyst has,” Moglione continued.
“But what we can challenge them on is barriers to entry and the competitive landscape, so what's going on with competitors, what's going on in the industry: it’s a second safety net.”
Even if the analyst passes the grilling from the rest of the team and the stock makes it into the portfolio, it is not safe from further challenges.
Moglione said that because the trust doesn’t have a head of asset allocation, there is a constant competition for capital. Therefore, if an analyst comes up with a compelling stock idea that passes the three steps mentioned above, the other members of the team will have to argue the case for holding on to their existing stock-picks rather than discarding them to make room for the new entrant.
“Your investments are constantly critiqued by the other specialists,” Moglione said.
“Competition for capital means that a fund manager with a natural bias can’t focus too much on the valuation, being enamoured with the management team or the amount of work they've done on the stock.
“If they can't defend that position against another new idea, it has to exit the portfolio.”
Data from FE Analytics shows Momentum Multi-Asset Value Trust has made 149.15 per cent over the past 10 years, compared with 79.85 per cent from the FTSE All Share and 56.89 per cent from the IT Flexible Investment sector.
Performance of trust vs sector and index over 10yrs
Source: FE Analytics
The trust is on a discount of 0.39 per cent compared with 1.76 and 0.19 per cent from its one- and three-year averages.
It has ongoing charges of 1.6 per cent and is yielding 3.62 per cent.