Corporate governance issues, bad debt and declining revenues are ways investors can avoid having too many poor stock and investment trust selections in their portfolio, according to fund managers.
Value investing has been out of favour for some time with investors and managers following the momentum trade – buying stocks that are performing well.
This has been a good place to be for much of the last decade, as the below chart shows, with the MSCI World Momentum index outperforming the MSCI World Value index by 88.95 percentage points.
Performance of indices over 10yrs
Source: FE Analytics
While value stocks have been unpopular, also knocking the index is the number of ‘value traps’ – companies that look like they are good value but are unloved by the market for a particular reason.
There have been a several recent examples of well-established value stocks suffering, from the collapse of outsourcer Carillion due to huge debts and Bargain Booze owner Conviviality thanks to falling sales. Meanwhile, the AA and Provident Financial saw unexpected profit warnings derail their share price.
Below, FE Trustnet asks Miton Group’s Andrew Jackson and the British Empire Trust’s Joe Bauernfreund – two fund managers with a value approach – how they look to avoid such potentially catastrophic mistakes.
Stocks
FE Alpha Manager Jackson, who manages the four FE Crown-rated, £430m LF Miton UK Value Opportunities, said there are a number of factors that investors can look for when it comes to picking stocks.
“Ones whose top line is going down suggests that is a business that is not in favour with its end customers and that is a troublesome start point,” the manager said.
“That is like running a fund that is losing money or outflows – it is hard. It is like walking up life’s down escalator.”
A good example of this is the high street retail sector, where a number of high profile brands have struggled to continue to get customers through their doors thanks to the rise in popularity of online shopping.
The second area to look at is costs and in particular high fixed costs, as these can prove extremely detrimental if the top line revenue begins to decline.
“[In this scenario] you have got this closing gap between turnover and cost which is declining profitability. If your costs are high and fixed, then that gap closes rapidly. If a large chunk of your costs is variable you can possible do more about it,” Jackson said.
For investors, it is important to look at whether or not these costs are fixed or rising – such as rent on buildings.
Taking the UK high street as an example, the LF Miton UK Value Opportunities manager noted that the costs of retail space can be quite high and are generally fixed for a longer period, as such they can be detrimental to businesses.
“Why are UK high streets in difficulty? Because a lot of their costs are really quite high. In fact, the costs are rising because they are having to compete online as well,” he said.
Finally, debt is an important factor and – in particular – high interest, legacy debt that can cause problems again if the cashflow begins to fall.
Jackson said: “Debt kills you. Debt sinks [companies]. If you have got something that is in terminal decline – if people are just not going through your stores for example so you have lost your customer – then you have got a problem.
“If you can’t manage the cost against that declining demand you have a bigger problem and if you have got a geared balance sheet then your problems really are bad.”
The Miton manager said ideally investors will look for companies that are on low price-to-earnings (P/E) multiples without these issues, but said that some can survive.
“In some companies you look at what you can do to turn it around. That is where you start playing with falling knives. You really want a business actually [that] does appear to be successful,” he explained.
Performance of stock over 3yrs
Source: FE Analytics
However, one example where there was a successful turnaround was Oxford Instruments, which was over-indebted but sold off its industrial analysis division meaning the debt was no longer an issue, Jackson said.
“We can all breathe easy and then ask if what they have got left is attractive or not and then you take it from there,” he noted.
However, sometimes it can work the other way, as was the case with Capita earlier this year, which despite selling off its fund administration business was unable to keep debts at bay.
“Capita was over-indebted and struggling to win new business,” said Jackson. “It sold off its fund administration business – a jewel – and it looked as though maybe its problems were over.
“But the fact was it had sold the family silver and the core outsourcing business was still failing to make progress and in fact was in decline.
Performance of stock YTD
Source: FE Analytics
“Then the debt was there so the decline wasn’t paying off the debt quick enough and suddenly you got this crack appearing.”
Trusts
Bauernfreund, who runs the £850m British Empire Trust and primarily focuses on investment companies trading at a low discount to net asset value (NAV), has a different approach to identifying value traps.
When looking at investment companies (including trusts) there are a number of obvious indicators that he looks for, the first of which is good corporate governance.
“Corporate governance ranges from a number of different things,” he explained. “It could be issuing shares at a discount, a lack of communication, ripping off shareholders by paying themselves too much money.
“All those sorts of things are a reason why a discount exists and you take that on at your peril really.”
Second, and similar to the stock examples above, Bauernfreund said is indebtedness – or in this case overleveraging or gearing.
“Underlying assets that are perhaps overleveraged, operating in zombie industries – particularly cyclical industries – and have high capital requirement, these are undesirable businesses and another reason why the discount could be a signal of declining value,” he said.
One area he said investors should spend less time worrying about is macroeconomics, noting that it is not something that he often concerns himself with.
“We are not primarily macro investors – we don’t think we are going to add much value on the macro front,” he said.
“In certain countries the macro-political situation will have more of a bearing on our thinking than in others, particularly in emerging markets where you have got more risks affecting currencies and we would consider that when it comes to seizing opportunities.”