Investors seeking value in battered stocks still risk poor timing and unwise moves. But even though prospects for value stocks are better in the long term, there is a shift to growth as the slowdown strikes, writes Paul Farrow.
Ask John Chatfeild-Roberts at Jupiter Asset Management what he thinks of value investors and he replies: “they are slightly mad”. He insists that this is not meant as a criticism but that is his take on the highly individualist nature of value managers and their ability to be thick-skinned.
They have a disciplined style, which means that they will ignore stocks that seem sure-fire winners. “Value investors have to go against the herd and are slightly mad because they are buying something and more of it, as the price falls and that is not easy to do,” says Chatfeild-Roberts.
It is a point that has not been missed by Bill Miller, the legendary fund manager of Legg Mason Value Trust, who is aghast that many investors do not seem to care much about valuations any more.
He adds: “It has been explained to me that it was obvious we should not have owned house-builders or retailers or banks and that I should have known better than to invest in such things. It was also obvious that growth in China and India and other developing countries would drive oil and other commodities to record levels and that related equities were the thing to own. ‘Don’t you read the papers?’ was the common comment.”
Miller is the latest value manager to come under the cosh. You may recall the late Tony Dye and Neil Woodford (who many would put in the value camp) were under severe pressure in the late 1990s because of their reluctance to join in the growth-orientated technology party.
Dye, the former chief investment officer of Phillips & Drew, who died of cancer at the age of 60 earlier this year, was dubbed Dr Doom because of his pessimistic view of the stockmarket during the technology boom in the late 1990s. He was forced out of the fund manager in 2000 because his prediction had yet to be realised but, within weeks of his departure, his contrarian stance was vindicated as the bubble burst and a bear market ensued.
Miller is facing a similar backlash because of his contrarian stance. Until 2006, Bill Miller was the only American fund manager to beat the S&P 500 index in 15 consecutive years. But his disciplined strategy of buying unloved shares has seen the wheels fall off spectacularly. The fund has dropped to the bottom end of the performance tables – the result being that dissatisfied investors have withdrawn billions of dollars. Many commentators are questioning whether Miller is a spent force. The Legg Mason Value Trust that he runs is down 30% this year.
Miller adds: “A group of us (known as the Value Support Group) were standing around a few weeks ago when Warren Buffett wandered over. We were commiserating over how badly we had done in this market, how valuation appeared not to matter and had not for the past couple of years, how it was all about momentum and trend, and how we were losing clients and assets over and above our losses in the market. We needed a 12-step programme to cure us of our addiction to buying beaten-up stocks trading at large discounts to our assessment of their intrinsic value.”
Miller argues that investors have ignored valuations. It is a view shared by Nick Purvis at Schroders who says that hedge funds are much to blame. “The markets are quite heavily dominated by hedge funds, which account for a large amount of the trading volumes – at the moment these are not focused on value – they have been selling consumer cyclicals and financials – and buying emerging markets,” he says. “These deals have come irrespective of valuations. The lowly valued have become even more lowly valued as a result. It has been a doubled-edged sword for those who focus on value.”
The value brigade has had a torrid time. The indices tell the story. The MSCI UK Value index has fallen 18% over the past year and a decline of 10% over the past two years. This is compared with the 4.8% fall in the MSCI UK Growth index over 12 months and a positive return of 5.4% over two years.
The debate on value versus growth has rumbled on for decades – ever since the 1930s when Benjamin Graham and David Dodd wrote their 1934 best seller, Security Analysis, that gave birth to the concept of value investing. Value is often defined by price/earnings ratios (P/E), price to book (the company’s share price divided by its net asset value) and dividend yield. Nobody said Graham and Dodd should buy shares with a P/E ratio of more than 16.
On the other hand, growth investors judge a stock on its future return on equity (profit after tax divided by its shareholder funds, its earnings growth, and sales growth and earnings forecasts). According to a pioneer of growth investing in the 1930s, T Rowe Price Jnr, growth stocks offer “favourable underlying long-term growth in earnings” and so give the only realistic prospects of outrunning the erosion of inflation.
SocGen agrees that these are dark days for deep value. Its basket of Graham-like stocks in Europe is down 24% so far this year. “In a world dominated by investors with chronic ADHD [attention deficit hyperactivity disorder], in which the majority of investors end up chasing their own tails, taking a long-term view will generate periods of underperformance,” says James Montier, an analyst at Société Générale.
The statistics show that over the long-term value wins the day over growth – the Brandes Institute dubs growth “glamour stocks”. The institute has also shown that the best long-term fund managers suffer periods of underperformance. In their worst single year, the best managers lagged their benchmark by nearly 20% on average. Even on a three-year view nearly 40% of the best managers were listed in the bottom decile in terms of performance.
One factor for the shift in sentiment towards growth stocks is the state of the global economy. Growth stocks tend to perform best when economic growth slows. Not surprisingly, the financial crisis is persuading investors to look to buy stocks that can grow with recession looming.
John Chatfeild-Roberts, Jupiter Asset ManagementStephen Marriot, at Bestinvest Mark Harris, a multi-manager at New StarJohn Husselbee, chief executive of North Style Research says that large value outperformed during the early history of the past 20 years. Growth, mostly large growth, outperformed during the late 1990s and small value outperformed dramatically over the past four years.
It also says that growth tends to struggle during times of high inflation. It is more difficult to manage a growth company during high inflation since investments are more difficult to budget in the uncertain future,” says Peter Hopkins, at Style Research. “At the up-turn of the economic cycle profitability is abundant and so growth opportunities are no longer the scarce resource; also smaller, often more risky, value companies benefit most from the upward reversal in sentiment. Also at the unnerving top of the rollercoaster, where you can’t yet see the bottom, worried investors huddle in value. But growth generally requires a ‘gestation period’ of economic calm to encourage investors and entrepreneurs to explore longer-term pay-off opportunities.”
Style investing and rotating between value and growth is deeply installed in the American investor’s psyche – in Britain it has struggled to take hold. We had a crack at introducing the style formula in 2000 when Schroders and JPM launched style ranges offering investors the chance to exploit either a growth approach or a value approach. It did not pan out as planned for Schroders, which shut down the range in June 2003.
JPMorgan stuck with its range of style funds for a little longer – and while it is still a roaring success in continental Europe, it has all but died out in Britain. One of the mistakes it made in hindsight, it admits, was that we put the fund in the wrong sector. It was put in the UK All Companies sector when it should have been in the UK Equity Income sector. Jasper Berens, head of sales at JPM says that UK Strategic Value did not work even though performance was strong – it attracted little money. “It was put in the UK All Companies sector, which was a mistake in hindsight. In the UK investors see value as equity income – and that is where the fund now sits. But in Europe it has proved popular with value outselling growth considerably over the past five years – although growth is more recently gaining sales.”
Indeed, those equity income fund managers that have a value bias have struggled the most. The Principal Income Study has just placed Anthony Nutt (Jupiter Income) and Carl Stick (Rathbone Income) both white list regulars, in the grey list because they have suffered from high yielding value stocks.
The question is whether it is too early to play the value card. Purvis does not give the impression that he thinks the value rebound is around the corner – but he says that ‘all the ingredients that fed the equity income sector post the tech bubble are in place’.
“It has been a difficult market and there are some extreme valuation differences in the market. The lowly valuations have had a torrid time whichever way you cut the market – lowly valued companies have fallen faster then the market. It is no surprise that equity income has suffered,” says Purvis.
“The flipside is that we are seeing some amazing opportunities. The mistake people are making is this is not about six-month performance. The outlook is still poor in the short-term. I am mindful to harp back to the technology bubble but the ingredientsare there. The markets are as dislocated as they were back then and that created the environment for income funds to do well.”
Chris White, a manager on the Threadneedle income team, reckons a tough environment will suit his style down to the ground, rather than out and out growth managers.
“We have been thinking for a while now that as long as commodity prices don’t lurch higher and wage pressures remain under control, the Bank of England may cut interest rates in the first quarter in 2009. This will be good news for banks, industrials, utilities and telecoms – four of the highest yielding sectors in the market,” he says. “Meanwhile, the select band of truly sustainable growth stocks will become ever more select as the economy reaches its nadir, and ‘supposed’ growth stocks that fail to deliver (because they are cyclicals) will get severely punished by the market. This suggests to us that income funds should resume their long-term outperformance of growth.”
SocGen insists that investors should keep the faith as “value isn’t dead”. One lesson from the Technology, Media and Telecoms (TMT) bust is that value will return to glory when investors lose their faith in the cyclicals pretending to be growth. Watch mining and the emerging market related plays, it says.
The investment bank argues that if value continues to perform as badly as it has the first half of the year, this will be one of the worst performances for value (relative to glamour) ever – even worse than the manic years of the TMT bubble.
“For those with patience this pain is more than compensated. Following periods of poor value performance, value tends to rebound strongly – delivering about 17% a year over glamour (for an average of seven years),” he says.
“The experience of the TMT bust may hold some lessons as to when to expect deep value to return to grace. It wasn’t until investors had totally lost faith in the cyclicals masquerading as growth that value started to return to grace. This time it is the mining and emerging market related plays that are cyclicals pretending to be growth. Their time in the spotlight may be drawing to the end.”
It is only natural to expect equity income fund managers to talk up their chances of delivering in the future. However, they have yet to get their message across to multi-managers or IFAs (see box, page 20) who continue to adopt a growth tilt to their portfolios. Many fund managers are pinning their hopes on large cap growth stocks to help them ride out the storm.
According to Style Research, which analyses more than 300 UK funds, over the recent months there has been a move away from value, but in the last few weeks there has been a slight tilt back. “There’s more of a move to value than there was, but there is not a clear wholesale move to that style – it is still very much neutral,” says Hopkins.
Even Miller is caught in two minds as to which way the markets will go. He asks the question whether it is obvious financials should be bought now, having reached the most oversold levels since the 1987 crash, and the lowest valuations since the last great buying opportunity in 1990 and 1991? Or is it obvious they should be avoided, since the credit problems are in the papers every day and write-offs and provisioning will likely continue into 2009?
He adds: “Is it obvious energy stocks should be bought on this correction in oil prices from $147 to $123, a correction that has wiped 25 points off the prices of companies like XTO Energy and Chesapeake Energy in just a few weeks? Or is it obvious that oil had reached bubble levels at $147, and that buying the stocks here, down 30% from their highs, is akin to buying homebuilders down 30% from their highs in 2005?
“I do think some things are obvious: the credit crisis will end, the housing crisis will end, and credit markets will function satisfactorily and house prices will stop going down and then start moving higher. It is obvious that the US economy, already the most productive in the world, will get even more productive and will adapt and grow. It is obvious stock prices will be higher in the future than they are now.” l
John Chatfeild-Roberts, Jupiter Asset Management
“If you have been a deep value investor over the past 12 months you would have lost a lot of money. On a five-year view it might be the place to be but on a one-year view, who knows, so I am sitting on the fence a little.
John Chatfeild-Roberts, Jupiter Asset Management
“I recall M&G in the early 1990s, they had a really bad time but once we were out of the ERM [Exchange Rate Mechanism] there was a bounce and suddenly they were at the top again. That will happen again – Bill Miller is down 30% this year against the US index, which is down 14% – it’s the same with equity income in the UK.
“If we thought we were seeing a bottom we would go into deep value. It is not yet. A drop in the oil price would be helpful and we have got to get the bottom in the US housing market because until you have had that there will be no stability in the US financial system.
“If value does come back into play I would look at Henderson Equity Income and the Lowland investment trust. Fidelity Special Situations would also suit a value investor as would Jupiter UK.”
Stephen Marriot, at Bestinvest
“Our fund we launched at the end of April has a growth bias partly because value had led the way for much of the previous six years. Growth tends to work late in the cycle because investors are prepared to pay for the reliability of earnings. There has been a market switch to large cap growth since the financials fell out of bed. Growth funds include Liontrust First Growth and Nigel Thomas’ Axa Framlington fund. If you are looking at value calls I would look at Jupiter Global Financials, Artemis Income and Henderson UK Equity Income. The market is very painful and in panic mode and it is not time to go value yet. But to be extreme underweight value is not sensible just know, there is a change ahead it is a question of when.”
Marh Harris, a multi-manager at New Star
“Style is a big driver of return. We don’t have much value in our portfolios, but we are not saying that would change. A lot of banks would be classified as value and we couldn’t see why we should hold them. We like Liontrust First Growth and BlackRock UK Alpha. If I was looking at an equity income fund I would look at Threadneedle Equity Alpha managed by Leigh Harrison as it is less deep value than its peers. If value came back into play I would look at Psigma Equity Income fund and New Star UK Growth, which was massively overweight banks.”
John Husselbee, chief executive of North
“You only have to look at Europe to give you an indication of how value versus growth has changed direction (or large versus small cap, for that matter). Last year it was back to growth and back to large cap – managers such as Chris Rice and Roger Guy were back with a vengeance. The special situations funds that had ruled the roost came unstuck.
“There is no doubt where the value is over the longer term but the same cannot be said over one, three, six months or a year. At the moment we are skewed towards a growth bias. Richard Plackett’s BlackRock Special Situations and River & Mercantile’s UK Equity fit the bill because of their large cap growth bias.
“We need clarity before we make the jump to value – if the price of oil falls below $100 that will be significant. That is when the likes of Bill Mott at PSigma Income will come into his own. I do believe there could be a champagne moment and when the cork pops markets will fly.”
Qualifying criteria for deep value
The list (supplemented by three of Rea’s own requirements) was published by Rea in a Journal of Portfolio Management article in 1977. To qualify as a deep value opportunity the following criteria must be met:
1) A trailing earnings yield greater than twice the AAA bond yield
2) A P/E ratio of less than 40% of the peak price/earnings ratio (P/E) based on five-year moving average earnings
3) A dividend yield at least equal to two-thirds of the AAA bond yield
4) A price of less than two-thirds of tangible book value
5) A price of less than two-thirds of net current assets
6) Total debt less than two-thirds of tangible book value
7) A current ratio greater than two
8) Total debt less than (or equal to) twice net current assets
9) Compound earnings growth of at least 7% over 10 years
10) Two or fewer annual earnings declines of 5% or more in the last 10 years.