The value style of investing has not been out of favour over the past decade, contrary to popular belief, so long as your strategy hasn’t started and ended with a focus on value alone.
This is according to George Godber and Georgina Hamilton, managers of the Polar Capital UK Value Opportunities fund.
Data from FE Analytics shows the MSCI United Kingdom Growth index has made 125.34 per cent over the past decade, compared with 87.59 per cent from MSCI United Kingdom Value, while the disparity in global markets has been even more extreme.
Performance of indices over 10yrs
Source: FE Analytics
However, Godber and Hamilton claim it has been possible to outperform via a strategy of buying companies on cheap P/E (price to earnings) ratios over this time, so long as you have been diligent enough to avoid value traps
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“Being cheap is not enough,” said Godber (pictured). “And it's certainly not enough in the UK market.”
The managers aim to identify two types of company: the first they call bargain assets, which involves the “classic Benjamin Graham approach” of finding a company available for 80p that they can sell for £1; and the second they call cheap value creators, where the market under-appreciates the return on invested capital the business is capable of generating.
However, there are two additional hurdles such companies must clear before they are added to the fund, the first of which involves making sure they aren’t being disrupted.
“If you're talking about an asset base, you need to know that asset base is stable, understandable, and you can value it whatever the weather,” Godber said.
“We've just had a major high street retailer in here telling us it is getting between 35 and 50 per cent rent cuts across the UK. But even though it is trading below its stated tangible book value, unless you're calling the turn of the high street, it wouldn't be something we would touch.
“Likewise, if you've got a return on invested capital going down, we are not trying to predict the turn without actual evidence.
“Marks & Spencer was doing £1bn of profit a decade ago, now it is doing £330m and there is no actual evidence of an improvement. And every pound that it is deploying seems to generate a worse return than the legacy core business.”
The second hurdle they must clear is what Godber calls a “draconian” test of cash flow, with the managers gauging this measure after all possible claims on the business. For example, he pointed out many companies over-distribute dividends, which can be detrimental to the long-term health of the business, while others use creative accounting to keep liabilities off their balance sheet.
“A lot of people say that if you're trading at 70p in the pound, your debt profile doesn't matter, but it really, really does, because in a market panic, you're only cheap because you are unloved,” Hamilton added.
“It's absolutely critical to marry a good balance sheet with valuation as a strategy, which is how we try to avoid value traps.
“It is worth saying that we don't believe that our brand of value has been bad for 10 years. We would say that buying cheap companies with trashy balance sheets is never a good strategy anyway.”
The managers admitted things have been more difficult over the past 18 months, however. While the headline valuation of the FTSE looks cheap compared with the rest of the world, the valuation differential between certain sectors in the index is even wider: a handful of companies trade at about 25x earnings, but a surprisingly large number are on single-digit earnings.
Performance of cheapest and most expensive FTSE 350 stocks
Source: Polar Capital & IBES/ Datastream. Date: As at 11 July 2019.
Hamilton said this discrepancy had been stretched to extreme levels up to the start of summer.
“The most expensive P/Es in the summer of 2018 were trading on about 25 times earnings and they have not de-rated at all,” she continued.
“And then the cheaper P/Es de-rated a lot. The cheaper you were at the beginning of the year, the worse you did. So if you had a P/E of say 20 times, you've made roughly 20 per cent this year, but if you had a much lower P/E, you've done much worse.”
Godber said things have improved for value stocks since the end of the summer, with three of the fund’s holdings on P/Es of seven or less rising by 20 per cent. None of these stocks saw any change in newsflow, with the movements being driven by sentiment alone. The manager said Legal & General was the best example of this.
“It had nothing fundamental change in its business model,” he explained. “By definition, buying a life policy tends to be a 30-year event for you as a consumer, or if you're a company doing bulk purchase annuities. It doesn't alter by 20 per cent in four months. But the stock market view of it changed very dramatically.”
Hamilton (pictured) said this serves to highlight what can happen when valuation discrepancies reach extreme levels.
“Where we stand today, we think the upside opportunity in the market is extremely attractive,” she added.
“We are not necessarily saying this is the turning point, because there's no God-given number that the stretch has to get to; it has been higher than that in the past.
“But what you can see is when you start at these extreme valuation levels, when things start to turn, the moves are fast and big.”
Data from FE Analytics shows Polar Capital UK Value Opportunities has made 17.8 per cent since launch in January 2017, compared with gains of 16.92 per cent from the FTSE All Share and 14.72 per cent from the IA UK All Companies sector.
Performance of fund vs sector and index since launch
Source: FE Analytics
The £1.1bn fund has ongoing charges of 0.86 per cent. It also has a 10 per cent fee of any outperformance of the FTSE All Share, with a high watermark.
Godber and Hamilton said this is so their interests are more aligned with those of investors, as it means they will not need to chase inflows – their strategy has a capacity of £1.2bn.