Yields of up to 20 per cent are now available on certain value stocks – and this is even after factoring in a pessimistic forecast of how the coronavirus will affect the underlying businesses, according to Philip Matthews of the TB Wise Multi-Asset Income fund.
The growth stocks responsible for much of the gains in world markets in the recent past have continued to power ahead this year, while their value counterparts have borne the brunt of the economic lockdown.
Performance of indices in 2020
Source: FE Analytics
Yet Matthews said this diversion means there is now a “once-in-a-generation opportunity” for anyone willing to look to areas of the market where there is a higher degree of uncertainty about the outlook to profits.
“At its low point in March/April, that dispersion between value and growth had never ever been as wide,” he explained. “That's a pretty good starting point to think about value.
“People don't like investing into increasingly bad news, although sometimes that's the best time to do it, because everyone is panicking. The stage we're at at the moment, valuations are very attractive in absolute terms as well as being even more attractive on a relative basis.
“There is a high degree of disruption, but businesses are trading on incredibly distressed valuations and if things return to normal, there is significant scope for share price appreciation.
“Our job is to make sure we're picking the companies that have got the balance sheets to weather this particular storm, where we think they can come out of this without being permanently impaired and can grow over the medium term.”
As an example of the extreme valuation discrepancies currently available, Matthews pointed to NewRiver, a REIT that owns retail and leisure assets such as shopping centres, retail parks and pubs.
Unsurprisingly, it has run into difficulties this year, with a number of retailers failing to pay their rent and the income from the pubs side of the business completely drying up. Yet despite these problems, Matthews said the market still appeared to have priced in an overly pessimistic scenario.
Performance of index in 2020
Source: FE Analytics
“Looking at a reasonable assessment of where things may go from here, even if it has to sell some assets to reduce the gearing levels in its business and assuming it loses some rent in the process, you're getting up to a 20 per cent yield on the share price at the moment,” he continued.
“And that feels to us to be way too high given the risks of what it is doing and the alternative-use value that sits within that portfolio.”
A period of reduced or non-existent earnings during the economic lockdown is not the only risk currently faced by value stocks. A perennial problem for bottom-fishing managers is ensuring they invest in a company that is being underestimated by the market and not a value-trap – a threat that has become more prevalent recently due to the heightened risk of disruption.
However, Matthews’ process involves looking for a number of tell-tale signs that indicate a company is falling behind the competition.
“A good starting point is, ‘has that business been able to grow it earnings over the past decade?’ as these forces of change have been very powerful over this time,” the manager explained.
“And a really good one to look at is, ‘just what percentage of profits has it actually converted into cash?’
“What you will see from a lot of potential value investments is that they tell you they're earning one level of profit, but actually because so much change is happening in that marketplace, they're constantly having to restructure and access that capital base they had beforehand to reposition for a new future.”
Matthews has seen examples in the past where the amount of cash a company was generating was less than half the level of profit it claimed. The manager said this was the case with Thomas Cook.
“It said it was earning one thing and I'm pretty sure that there was a period where I looked at it and cumulatively over a decade it had delivered no cash, because it was just constantly restructuring and it had a big pension fund deficit and stuff like that,” he added.
“Value investors have got to be highly cognisant that there is an awful lot of disruption taking place at the moment which is massively changing business models.
“But equally there are some businesses that are able to adapt and there are some businesses that have got cyclical earnings and, at a point in time when cyclical profits are in a trough, the market can be overly pessimistic towards them and you can buy them on incredibly low valuations.”
Data from FE Analytics shows TB Wise Multi-Asset Income has made 8.93 per cent over the past five years, compared with 27.35 per cent from the IA Flexible Investment sector and 10.82 per cent from the CBOE UK All Companies index.
Performance of fund vs sector and index over 5yrs
Source: FE Analytics
The £85.5m fund has ongoing charges of 0.88 per cent and is yielding 6.7 per cent.