Investors should ignore the widely touted view that struggling ‘deep value’ equity funds are going to start outperforming their more growth orientated rivals, according to FE Alpha Manager Margaret Lawson, who argues that the ‘value’ part of the market may well be cheap from a relative perspective but is littered with poor companies.
Funds with a value bias have, more often than not, found themselves in the third or fourth quartile in their respective sectors over the past three or so years while those which focus on companies generating growth have significantly outperformed.
There are a number of reasons behind this dynamic, whether that be the market favouring companies that are demonstrating growth in a low growth world or because fixed income investors have been forced out of the bond market (due to extraordinary monetary policies) and found solace in defensive, non-cyclical dividend paying growth companies for yield.
It must also be noted that value stocks tend to be highly cyclical and many have therefore struggled in the face of falling commodity prices and slowing Chinese growth.
Either way, data from FE Analytics shows that the MSCI United Kingdom Value index has underperformed the MSCI United Kingdom Growth index by some 20 percentage points over three years on a relative basis.
Relative performance of index over 3yrs
Source: FE Analytics
It was last year when genuine value managers really felt that underperformance, with the likes of M&G Recovery, Schroder Recovery and Standard life Investments UK Equity Recovery all finding themselves in the IA UK All Companies sector’s bottom decile in 2015.
As the graph above shows, though, that trend has started (albeit very tentatively) to reverse over recent months as investor appetite for risk has picked up with a recovery oil price, signs of stabilisation in China and dovish comments from leading central bankers.
As regular FE Trustnet readers will have noticed, many industry experts believe this will continue given the valuation differential between value and growth stocks and the belief that too much bad news is now priced into the value stocks’ shares.
Lawson, who co-runs the top-performing SVM UK Growth fund, says investors should not blindly follow these views, however. 
“Investors can gain from clear thinking about style, but unfortunately, labels like “value” and “growth” are often misunderstood. For investors concerned that growth shares have had a good innings, switching now into deeply discounted businesses may not be the answer,” Lawson (pictured) said.
She added: “Valuation itself looks like a flawed tool for value investing.”
As mentioned before, many have suggested that now is the ideal time to buy value funds.
Over recent months the likes of Chelsea Financial’s Darius McDermott, Invesco Perpetual’s Nick Mustoe, R&M’s Daniel Hanbury and many others have said the odds are now heavily in favour of value funds beating growth funds over the medium to long term.
Peter Toogood – investment director at City Financial – added that value funds are now almost guaranteed to outperform. He argued that if there was a 2008-style crash value stocks would outperform growth because they would already be cheap as few currently own them.
Or, if economic growth revives in the second half of the year, Toogood says that this would cause value to also outperform like it did in the build up to the global financial crisis.
Performance of indices between 1998 and 2008
Source: FE Analytics
However, Lawson says that investors are taking a huge risk in today’s market backdrop by just buying stocks because they appear cheap.
“It is better to think about longer term risks to a business, rather than today’s valuation or growth estimates,” Lawson said.
“For investors who rarely sell shares, the long term return will eventually be much like the underlying business performance. This points to favouring a good business, with opportunity to deploy the cash it generates. A contrarian approach can help identify good entry points to buy these types of shares.” “Investors should recognise that the biggest danger is poor underlying long term returns in a business. This is often created by bad management or governance, or simply by being in an area that is likely to be disrupted by new entrants. Businesses that collapse typically show high levels of borrowing, weak business models or questionable accounting.”
“These can be value traps – few are good at pricing inherently risky businesses.”
Indeed, when you look at the biggest constituents of a UK value index many would argue that they are understandably out of favour and optically cheap. These would include mining, oil and banking stocks which face various headwinds due to macroeconomic trends and tighter regulations.
Performance of indices over 5yrs
Source: FE Analytics
That being said, one of the biggest determining factors of an investor’s returns is the price they pay for an asset. Therefore, proponents of value funds argue that investors are putting their portfolios in even bigger danger by backing expensive defensive growth stocks following their stellar rally over the past seven years.
However, Lawson says she and her team can still find good quality companies that are demonstrating growth – but haven’t been bid up to high share prices.
“In many sectors, there is potential for new entrants to change economics. Think of what’s happening on the high street as online sales erode the customer proposition of many. Even the collapse in oil prices has been driven by disruptive new technology in US shale drilling,” Lawson said.
“Investors need a contrarian approach to finding good, growing businesses. It may mean largely ignoring sectors such as banking that are ripe for disruption. There are still companies that have genuine growth potential, but are simply misunderstood.”
Lawson has managed her five crown-rated SVM UK Growth fund since October 2005 and was joined by co-manager Colin McLean in February 2008.
As to be expected, she takes a growth-orientated approach to the UK equity market and has a genuinely unconstrained remit meaning she can hunt within large, medium and small-sized companies for opportunities.
However, though it is a multi-cap fund, she has historically been overweight mid-caps which has proved to be a successful strategy.
Performance of fund versus sector and index under Lawson
Source: FE Analytics
According to FE Analytics, the £140m fund has been a top decile performer in the IA UK All Companies sector since she has been at the helm with returns of 215.37 per cent, meaning it has beaten the FTSE All Share by more than 130 percentage points.
It is also top decile over one, three, five and 10 years having outperformed eight of the last 10 calendar years.