Square Mile: The volatility of value investing

Last month’s column provided an overview of some of the main investment styles employed by fund managers. This column undertakes a deeper dive and takes a closer look at managers following a value approach. Most managers acknowledge the influence of Graham & Dodd in their investment approach and the pivotal influence on the investment management industry since ‘Security Analysis’ was first published in 1934. Their work is often seen as the root of the value approach. Most investors recognise the need for an element of valuation discipline in their approach though there are many ways to calculate the ‘intrinsic value’ of a security.

Deep value approaches that are almost fully driven by comparing a stock’s valuation to its history are relatively uncommon. Almost by definition, this approach identifies companies that have fallen upon hard times and the investment opportunity comes from the belief that other investors have become overly focused on the downside risks inherent in the business. At times, a typical deep value portfolio reads like a ‘Who’s Who’ of corporate disaster stocks but it is this recent history that provides the managers the opportunity to buy into the shares so cheaply.

However, such an approach can generate extremely volatile returns. During recovery periods in the market cycle such strategies can absolutely fly, while in bear markets the drawdowns can be brutal. Thus funds following such a strategy are either best used for investors as a component in a wider portfolio or for clients who are seeking a very aggressive investment strategy. Square Mile consider River & Mercantile UK Long Term Recovery and Schroder Recovery as among the best deep value funds investing in the UK.

For many investors, such funds are a little just too prickly and demand in the funds market seems to be higher for a more rounded approach that is not quite so focused on a pure valuation methodology. Interestingly, River & Mercantile offers a UK Equity High Alpha strategy and Schroders an Income version of the recovery strategies, both of which have higher asset levels than the focused strategy. These funds both have a significant value bias though, which incorporates other factors that ameliorates some of the risks of a purer value approach.

There are a number of other approaches used by UK orientated funds such as Investec UK Special Situations. The fund’s long time manager Alastair Mundy does have a heavy focus on stocks trading on distressed valuations. His approach is genuinely contrarian but his team keenly focuses on the downside risk and occasionally use derivatives for risk management purposes in order to reduce volatility and help protect capital. This contrasts with the approach taken by Ben Whitmore in running the Jupiter UK Special Situations fund. Common to other value funds, Mr Whitmore screens the market looking for stocks trading cheaply compared to their long term history but he additionally considers the quality factors such as return on capital. This helps direct the fund away from firms with questionable business models. He will also build significant cash positions and concentrate the portfolio at times when he feels that his opportunity set is limited. This approach helps generate a smoother return profile for his fund holders.

A further fund worthy of consideration is the Fidelity Special Situations fund, once managed by the illustrious Anthony Bolton. Since 2014 the fund has been run by Alex Wright. With a view that the market can be slow to react to a changing situation, Mr Wright searches for unloved and out of favour stocks which are entering a period of positive change. He is ultimately looking to purchase companies before the market has recognised their improving growth prospects and as such, he has a value and contrarian investment style. This is an all cap strategy meaning that Mr Wright will invest in medium and smaller sized companies, as well as the largest. Alternative value approaches are also employed by the highly regarded Derek Stuart of Artemis Special Situations and Henry Dixon of Man GLG Undervalued Assets.

Of course the value approach is not only used in UK equities. Several of the managers listed so far have taken their process and applied it to global stocks. River & Mercantile, Investec, Jupiter and Schroders all now offer fund buyers an international equities option that are run alongside their traditional UK funds. More country specific funds are also available. Man GLG Japan Core Alpha follows a deep value, return to mean strategy which has been enormously successful over an extended period. Whereas in the US, the longstanding value approach employed by Dodge & Cox, available to UK investors through their US Stock Irish UCITS fund, has added value in a market that is notoriously difficult for active managers to achieve excess returns.

The value approach is volatile and can be out of sync with markets for a lengthy period of time. This can make investors uncomfortable but over the long term there is plenty of empirical evidence demonstrating the impressive efficacy of the approach.