A “naïve” belief in a reversion to the mean will likely make value investing a very poorly performing strategy, due to an unprecedented level of industry-wide disruption, according to SVM Asset Management’s Neil Veitch.
Value as an investment style has largely fallen out of favour as the low interest rate environment of the past decade has pushed investors into growth stocks.
Performance of style indices over the past 10yrs
Source: FE Analytics
As the above chart shows, the MSCI United Kingdom Quality and Growth indices have soared over the past 10 years, rising by 66.98 per cent and 57.32 per cent respectively, while the MSCI United Kingdom Value index has trailed with a 31.91 per cent total return. 
“The investment backdrop is becoming increasingly bifurcated between a relatively small subset of stocks, quality or growth – label it what you what you will – that continues to significantly outperform and leaves everything else in its wake,” said Veitch (pictured), co-manager of the SVM UK Opportunities fund. “There’s a number of reasons for that.
“In a world of heightened uncertainty – whether that’s Brexit, the Fed tensions or the China economic backdrop – investors are prepared to pay for what they perceive as visibility of certainty. And there are very few stocks nowadays that potentially offer that.
“There is scarcity value attached to some of these and that reflects many of the problems with some of the structural traditional safe havens on the market.”
Sectors such as utilities, tobacco and telecommunications where investors may expect reliable income streams are coming under increasing pressure from changing consumer trends and regulatory action, said Veitch.
With high levels of uncertainty around the traditional equity ‘safe havens’, investors have fewer alternatives to turn to.
“What that means I think leaves a lot of investors scratching their heads,” said the SVM manager. “So many of those traditional safe havens that investors would have rotated into when the economic outlook receded are no longer available to them.
“Therefore, they are focused on an ever-smaller sub-sector of the market.”
He added that investors are being crowded into stocks that have a high degree of defensiveness, good quality cash flows, strong balance sheets and with some an economic moat, highlighting companies such as Diageo, Unilever, Experian, Rentokil and London Stock Exchange.
As such, value-orientated investors face a conundrum. While they are good businesses, the fund manager explained, the valuation premium has become too large.
“It’s difficult for a value investor, you run the risk of being a broken record, you sit here every year saying that value is undervalued or cheap relative to growth, but it’s like waiting for Godot: the day never comes,” he said.
“It’s important to recognise, however, that our naive belief in reversion to the mean for value investors will in all likelihood be a very poorly performing strategy because we are seeing an unprecedented level of industry-wide disruption.”
Veitch said new technologies have fundamentally altered the way companies do business and that assuming profitability will revert over time to a longer-term average is “a fundamentally flawed strategy”.
Yet, he said that value as an investment strategy has not been completely negated.
“The difference in valuation between stocks that are fundamentally the same businesses, but whose earnings will exhibit a degree of cyclicality, and those stocks that offer that apparent illusion of certainty has become far too wide,” said the fund manager.
“It’s a concern as it may take an economic downturn to see that difference normalise.”
One such example is airline group IAG – the parent company of UK and Spain flag carriers British Airways and Iberia.
Performance of stock over 1yr
Source: FE Analytics
He said: “IAG certainly should continue to grow unless we suddenly become concerned about our carbon footprint and all resolve to cut our flying to one trip a year, which personally, I don’t think is a terribly likely outcome.
“If we look at the multiples these stocks are currently trading on, [the markets] are assuming their earnings will decline 30 to 40 per cent, which is a possibility, but I don’t think a probability.
“From our perspective, there’s a lot of long-term opportunity and many successful businesses because the market is throwing the baby out with the bathwater.”
However, while opportunities have emerged it has been a difficult period for the fund, which lost 8.2 per cent in the year to 30 June 2019 compared with a fall of 2.31 per cent for the IA UK All Companies sector average and a 0.57 per cent gain for the FTSE All Share index.
“Quite frankly, the last 12 months has probably been one of the most – if not the most – challenging periods bar the financial crisis in the 20 years I’ve managed money because we’re not your classic deep-value fund looking to buy the cheapest stocks in the market,” Veitch continued. “Sometimes value investors get too hung up on absolute valuations, which is relatively straightforward to define, and don’t pay enough attention to what the underlying quality of a business is.
“Ultimately, we want to buy reasonable businesses at attractive prices.”
However, Veitch said that investors need to be wary of conflating cyclical trends with structural trends given the amount of disruption across industries.
“Too many cyclical businesses have been lumped in altogether with little differentiation amongst them and some of them are fundamentally sound businesses but their earnings will be more volatile than the average,” he said. “Over time they should continue to grow, yet the market is pricing them, ultimately, as a zero-sum game.”
Nevertheless, the fund has 39.5 per cent of its portfolio in cyclical stocks and a further 19.5 per cent in consumer cyclicals.
“We do have an overweight to cyclical stocks and, truthfully, that doesn’t feel that comfortable at this point in the cycle,” he said. “But the valuation discrepancy in our mind is just too, too large and even while we recognise that some of these businesses will feel earnings come under pressure if we should go into a downturn, that is already reflected in the valuation.”
Veitch has overseen the SVM UK Opportunities fund since January 2006. Having previously managed the fund alongside veteran investor Margaret Lawson, he was joined by deputy manager Craig Jeruzal in 2014.
Performance of fund vs sector & benchmark under Veitch
Source: FE Analytics
During his time on the fund, it has made a total return of 188.06 per cent compared with 132.67 per cent for its FTSE All Share benchmark and a gain of 124.42 per cent for the IA UK All Companies sector average. It has an ongoing charges figure (OCF) of 1.03 per cent.