A good catch

Fishing for unloved stocks in turbulent times carries risks – but hefty rewards await the skilled and tenacious. So how do the experts tell whether a sector has value after it has sunk to the bottom? Cherry Reynard investigates.

Buying low and selling high is the investment holy grail. Unfortunately, it goes against human instinct to buy when a sector or market does not have the comfort blanket of other supporters. This can be seen in fund flows, which are consistently channelled into top performing sectors. 2007 has been a turbulent year with several sectors marked down substantially. For those investors with the courage for the long game, which of these areas hold value?

The best fund of funds managers and stockpickers buy at the time of maximum pessimism. But this is not easy to spot and it is easy to fall into the “value trap”. This is where stocks appear to have good value, but without a catalyst to release that value, they remain cheap for a long time. Many contrarian investors choose to miss out on investing at the absolute bottom in order to see a catalyst for a turnaround before investing.

So how do the experts tell whether a sector has value after it has fallen or whether it has further to fall? John Chatfeild-Roberts, head of fund of funds at Jupiter, says it is a question of judging the market conditions to see whether it is a manager that is underperforming or whether his style is unloved. He says this was particularly true with Neil Woodford, whose fund lost 20% of its value between September 1999 and March 2000.

Chatfeild-Roberts gives the example of Axa Framlington Growth. This has had a difficult time in the value-focused markets with assets falling to about one fifth of their previous value. Chatfeild-Roberts says: “Often people are moved on or made to change their ways, but the manager was doing the same job. We thought growth may come back into favour. He said we were the first people to see him for three years.”

On the funds side, Robert Burdett, co-head of the Thames River multi-manager team, says the great contrarian investors like Andrew Green of GAM look at 30 to 40-year sector trends and will build positions in deeply unloved bits of the market. Crispin Odey of Odey Asset Management and Hugh Hendry of Eclectica Asset Management also have a proven track record in this area.

This year, there have been some disaster areas – banks, Japan, commercial property shares – and some difficult areas: corporate bonds, North America and equity income. If any were poised for an upturn, it would be easy, but that does not tend to be the case in unloved sectors, which often fall further than expected. But for the robust, there are select opportunities:

After the credit crunch the banking sector has been swept to new lows, taking many other financial stocks with it. The global financials sector is down 11% on the year, according to MSCI Barra. But within that consumer finance stocks are down 23%, diversified financials down 15% and speciality mortgage finance companies down 53%.
Investors can pick up the bulge bracket British banks like Lloyds TSB on 8.36 times earnings with a dividend yield of 7.85% (source: Hemscott), or HBOS at 6.7 times earnings with 7.05% dividend yield. Even globally diversified banks like HSBC are trading on just 10.5 times earnings with a dividend yield of 5.66%. These are on historic earnings and profits are expected to fall, but when will this sector start to look cheap enough to buy?

The answer is different for corporate bonds and equities. On the bond side, James Gledhill, co-head of fixed income at New Star, says there are some technical problems keeping spreads wide for the banking sector. The most important is the wide availability of paper: Investors have offloaded banking bonds, because in illiquid markets they tend to sell their most liquid holdings and much of the corporate bond market has been ‘closed for business’ since the start of the credit crunch. This has come on top of much issuance, leaving many bonds to be digested by a reluctant market. He says that BBB corporates are trading at lower levels than AA-rated banks and one side of the equation has to change.

The second factor keeping prices in the banking sector low is sentiment. Gledhill says: “Investors remain nervous of the profitability of banks. The problems are not big enough for a default, but they are big enough for people to worry about an information black hole. People are not at all confident that they are being told the truth.”

But are they a bargain? Gledhill says: “I do think they are offering value. Corporate bonds are cheap compared with fundamentals, but the timing is difficult. On a year time horizon I’d be happy to invest, but they could be hit again before Christmas.”

Equities are more sentiment-driven, so the case is less clear. Sentiment could get worse before it gets better. However, Jeremy Podger, manager of the Threadneedle Global Growth fund, says that when financials finally turn the corner, they will rally quite sharply. He says: “Financials have underperformed the market significantly both in price to earnings and price to book terms. The ratings are not that dissimilar to those seen in the darkest days of the 1990s recession.”

This is a different economic environment and Podger says companies like Sony Holdings have been over-looked. He says he is not rushing into financials at this stage, but there is value in some areas. To distinguish quality financials from the problem areas, he is looking at the quality of the assets, the ratio of deposits to loans, the lending spreads and the security of the balance sheet equity ratios.

Gavin Haynes, investment director, Whitechurch Securities, says managers like Philip Gibbs of the Jupiter Financials fund will find opportunities among the indiscriminate sell-off in financials. Insurance companies, for example, have been marked down alongside other financials. The fund has proved itself a winner over the long-term and remains up this year, but has underperformed both the IMA Specialist and All Companies sectors.

Corporate bonds Financial corporate bonds may offer selective value, but what about the wider corporate bond market? After several strong years, which saw spreads over government bonds narrow significantly, the past 12 months to November 19 has been difficult. Just 18 out of 95 funds in the UK Corporate bond sector showed a positive return and an average fall of 1.4% with income reinvested, according to Morningstar.
As the credit markets have shut down some capital-intensive sectors have been hit particularly hard, including steel, chemicals and other cyclical industries. Gledhill says: “Most bonds look pretty cheap and some things look really cheap. Some bonds are trading at distressed prices that just aren’t distressed.” Until the credit crisis is resolved, there is unlikely to be any sustained recovery in corporate bonds, but the default rate remains at historic lows. The next 12 months are likely to be more difficult, but no-one is forecasting a material rise in the level of defaults. The state of corporate balance sheets and profitability remains good.
However, Gledhill admits that there are a lot of forced sellers and no buyers and confidence is weak. He says: “It should be a buying opportunity in the long term, but there is going to be some discomfort in the meantime. The opportunities are fairly stock specific because everything has been traded down together.” In the hands of talented stockpickers the corporate bond market should offer plenty of upside and investors should feel more comfortable investing than 12 months ago when spreads were at historically low levels over government bonds.

Commercial property
After three years of strong performance the commercial property sector hit problems in 2007. It has sailed along on more than 20% returns for the previous three years, substantially outperforming most equity and bond markets and its long-term average. Reits were introduced at the start of the year and about half the British commercial property sector converted. This should have left commercial property funds trading closer to net asset value as there was less tax to pay. Instead, the sector collapsed and is down 33% on a year ago,according to FT sector indices.

Direct property has suffered, with the Norwich Property fund down 7% on the year to November 19, according to Morningstar, and the New Star Property fund down 9.3%. However, it is commercial property shares that have seen the biggest mark-downs. The Aberdeen Property Share fund is down 32.5% on the year, for example. Property shares are trading on substantial discounts to net asset value – typically 35-50% – as they are building in a significant reduction in capital values at their next valuation.

No-one disputes that asset values will come down. Alex Ross, manager of the Premier Pan-European Property Share fund, says: “Certainly, NAV will fall, so our real question is where shares are trading relative to real net asset value. It has become difficult to borrow money. The disadvantage of quoted property in this market is the effective gearing. But even if commercial property values fall 15-20%, at the current prices there is value there.”

However, Ross admits that sentiment is so bad towards the sector that it is difficult to see a sustained recovery in the short term. News flow is poor, banks are reluctant to lend and borrowing costs are relatively high. The next few months will see property companies revising their NAVs downwards, which may prompt selling by the hedge funds. Direct property funds are being forced to sell their property shares for liquidity purposes.

But there is hope in the longer-term. The fall in interest rates forecast for early next year would be good for the sector. If prices stay at their current discounts a bid becomes more likely. Ross says the market is pricing in a 1990s-type crash in commercial property prices, but argues that the economic environment is different. He adds: “In the medium term, when the credit crunch sorts itself out, with a lower interest rate environment and corrected property values, yields will be higher and it is amazing how quickly the sector can turn around and come back into favour. However, I don’t see a catalyst to get property shares surging ahead in the long-term.”

Nick Greenwood, chief investment officer at iimia, says that, although sentiment is at rock-bottom in the British property sector, it remains a relatively dangerous area to invest in the short-term. He says foreign funds look safer and have seen similar mark-downs. He says: “There are property companies that have assets in markets that aren’t slipping – Bulgaria, Japan, Germany or India, for example. They have been hit like everything else. There are no buyers for anything.”

Burdett agrees that better value may be found abroad. He says: “There have been some brutal falls in the property equity space and it will come to a point when it is over-done, but sentiment still has further to go and at the moment our only holding is an Asian Real Estate fund, which offers a higher yield and a different outlook.”

The country has been on the verge of a turnaround for as long as anyone can remember. It has seen false dawn after false dawn. But this year marked the end of the road for many investors. The Nikkei is down 12% on the year compared with a fall of 2.4% in the FTSE 100 and a rise of 1.6% in the S&P 500, to November 22. The average Japan fund is down 9.7% with the average Japanese Smaller Companies fund down 13.6%. As Greenwood says: “Japan has been in a bear phase for 18 months. The last seller has given up. Expectations are so low, that things may actually be okay.”

Haynes at Whitechurch points to a few reasons to be optimistic about Japan. He says: “Many investors have already thrown the towel in on Japan. But there are good reasons to look again at the sector. Scott McGlashan, manager of the JOHCM Japan fund, has always been bearish on the region, but is saying it could be the start of a bull market. Also, the region does not have exposure to the credit crunch. Most importantly, everyone hates it. It is the point of maximum pessimism.”

McGlashan’s views have some credibility: While working at Invesco Perpetual in the 1990s he told investors to steer clear of Japan. Many thanked him for it as Japanese markets embarked on a 10-year bear phase. He says corporate fundamentals are strong, valuations are attractive and the markets are supported by good dividend growth, up 15-20% over the past four years. Merger and acquisition activity is increasing and domestic investors are buying in.

Burdett also says that the region is starting to look interesting despite ongoing political problems. Hideo Shiozumi’s Legg Mason Japan fund has had a torrid time, as its small cap, growth bias put it in the worst-hit areas of the market, but it bounced 15% last month. Burdett says this shows that when the bounce comes, it can be violent. He adds: “Japan has been benefiting from the growth in most of Asia and there is a currency benefit on top of the stockmarket.”

However, Podger sounds a note of caution. He points out that in local currency terms the difference between Japanese markets and other global markets has not been as profound. He says there is value in Japanese markets, but it is by no means universal. He says: “KDDI has been a winner in the mobile telecoms market. It has been picking up market share and delivering modest top-line growth. Yet it is down 6% year-to-date. I would compare that to FranceTel, which has a similar profile, but is up nearly 30% on the year. KDDI is cheaper on most measures. They have world class companies in electronics, but Japanese financials, for example, do not stand out in their own right.”

To the untrained eye, America looks to be in a terrible mess: It was the source of the subprime problems with both its investment and commercial banks dragged into the chaos; Its housing market is in decline; Economic forecasts are weak; Its currency is on the rack and it is overloaded with debt. Although its stockmarkets have held up reasonably well, the average America fund has delivered is down 1.3% over the past 12 months, 4.7% lower than the return from the average UK All Companies fund. Yet many are predicting a strong year for the American market. Why?

Burdett says he has more invested in America now than he has for many years. He adds: “On a relative basis the stockmarket and currency look cheap, though the currency may be an issue in the short term. Many of the managers are more excited about their market than I have seen in a long-time, which is a good sign. It is such a fantastic stockpickers’ market that it is always an interesting place to be invested.”

Haynes agrees: “The domestic environment does not look good, but there are several reasons to buy in: The dollar is so weak it makes US exports competitive; Also, the S&P is on its lowest rating for about 15 years; And a climate of falling interest rates should support the market. Also, if the global economic environment does get worse, traditionally the US has not been a bad place to be. Other places usually suffer a lot worse.”

Equity Income
This is the natural home of the contrarian. Often if a company has a high dividend yield, it is because its share price is relatively low. This year, the sector has underperformed the UK All Companies sector, returning just 6.9%, compared with 10.6%. It is also down over three and five years, despite its strong run in the first few years of the century.

Haynes says it might be ready for an upturn. He says: “Income stocks have suffered and the changing economic outlook may favour a defensive, quality bias.” Hugh Yarrow, assistant manager of the Rathbone Income Fund, agrees: “While investors have charged into ‘growth’, some selective value has started to emerge in stocks hit by market conditions this year. Over the past few months, sector leadership has narrowed as stocks are sold, sometimes indiscriminately, to finance investments in more fashionable, momentum-driven areas. However, despite this shift, our long-term strategy has led us to channel profits, albeit tentatively at this stage, from those momentum sectors into more select unfashionable value plays.”

However, Burdett and Podger say that equity income is largely a proxy for value stocks and this area of the market has only just started its run of underperformance. The strong run in value has created some anomalous ratings in the market: British American Tobacco, for example, is an old-fashioned cash-generative value stock and is trading on 16 times earnings, well ahead of the rest of the market. This rating is in line, or in some cases higher, than typical growth stocks.

Burdett says: “We think this is just the beginning of equity income underperformance. Growth was due a rebound and this has started. However, equity income does have a heavy financials bias and there could be a snap rally if sentiment towards the area changes. We do hold selective income funds, like those from JO Hambro Capital Management and Psigma, but we prefer growth sectors.”

Podger says: “Growth stocks are one area that has been progressively derated over a long period. Value stocks with high asset backing have performed well since 2000. Value and growth converged across sectors because people did not want to take the risk on growth characteristics.

“Those companies with non-cyclical growth are being revalued. In the third quarter, there was acceleration in top line growth for faster growing companies. In other words, companies that were already growing fast, grew faster.” This was the case in America for companies like Microsoft and Cisco, but also for selected European stocks like Merck, Nokia and Roche.

But not all cheap areas have value and with markets likely to remain turbulent into the start of next year, even if they do have value, it may not be realised in the short term. Fishing in the bombed-out areas of global markets is for those with a strong constitution only, but this bravery is likely to be rewarded over the longer term.

Investment trusts
The troubled areas in the investment trust market mirror the situation elsewhere, with a few exceptions. Japan has been knocked down and most of the major Japanese investment trusts are trading at double-digit discounts. Fidelity Japanese Values is on a 16% discount, JP Morgan Fleming Japanese Smaller Companies trust is on a 14% discount. Property has also been marked down. Greenwood points out that investment trust investors are getting a double discount on the net asset value of the property – one on the investment trust and another one on the underlying shares.
Although small caps do not look good value relative to the rest of the market, Greenwood says that some of the better smaller companies trusts offer substantial value. The top performing Aberforth Smaller Companies trust trades on an 18% discount to net asset value. The Throgmorton trust, managed by Framlington smaller companies manager Roger Whiteoak, trades on an 18.5% discount.