What is value investing?
‘Value’ is the name given to investment styles that favour ‘unloved’ companies whose share...
Each week there is an almost overwhelming amount of economic data published by governments and agencies around the world. We get reports on inflation, unemployment, money supply, mortgage applications and consumer confidence, to name but a few.
At stock level there are even more measures that can be used to assess a company’s health or value: P/CF, P/E, Yield, EV/Sales vs peak margins, P/B, EBITDA, DCF… the alphabetti spaghetti list goes on.
Most investors simply don’t have the time or resources to track and understand fully all these market indicators and stock measures, so we asked a few fund managers if they could name just one or two that might be worth keeping an eye on.
PMI was a popular choice for an economic indicator. PMI is the abbreviation for the Purchasing Managers Index and it gives one of the first indications of economic conditions each month. The data is based on new orders, inventory levels, production, supplier delivery and the employment environment of private sector companies. The idea is that purchasing managers are among the first to notice a change in trading conditions and PMI figures are statistically-strong indicators of the near-term outlook for the manufacturing and services sectors of an economy. A reading of over 50 implies economic expansion, while less than 50 indicates contraction.
Bryn Jones, manager of Rathbone Ethical Bond, considers PMI an important measure for bond investors. In very simple terms, if the UK economy is expanding, he would ultimately treat this as a sell signal for UK government bonds and would look to decrease the interest rate risk in his portfolios.
PE is a way of measuring the value of a company’s shares. There are many ways to do this, but the PE ratio (the price to earnings valuation measure) is the most commonly cited.
The PE ratio is calculated by dividing the current share price of a company by the earnings per share. It is a simple way of assessing whether stocks look “cheap” or “expensive” relative either to their own history, or to other companies in their sector. The lower the number, the cheaper the stock.
Crucially, there is a wealth of academic evidence which demonstrates that if you buy a stock when it is cheap you have a better chance of making money over the longer term than if you buy it when it is expensive.
Nick Kirrage, co-manager of the Schroder Recovery fund, prefers the Graham & Dodd PE. Rather than referring to a single year’s earnings number, it uses an average of 10 years to smooth out the inevitable peaks and troughs of profitability. “A ten year period has the benefit of capturing the profits (and losses) of a full economic cycle, which paints a more representative picture than any one year could do on its own,” he said.
In fixed income, one of the easiest measures to use is yield. For example, if you take the 10-year UK government bond yield as the ‘risk-free’ rate, any extra yield you get on a corporate bond above this amount tells you how much you are being paid for the extra credit or default risk. You can then decide if you think the bond yield is paying enough or if you think the risks are greater than the reward.
As useful as these indicators undoubtedly are, as Richard Colwell, manager of Threadneedle UK Equity Income fund, points out, there is no silver bullet. He looks at a variety of metrics and tries to find a different angle to the one the rest of the market may be focused on.
Indeed, all of the managers we spoke to use myriad inputs to inform their investment decisions.
James Henderson, manager of Lowland Investment Company, added: “As a stock picker, we don’t form strong macro-economic views, but take into consideration the overall state of the economy, government policies and how they affect the sectors and companies we invest in.
“To gain a better understanding of a sector or company we analyse a broad spectrum of metrics, preferring those that are derived from actual data rather than projected forecasts or provisional figures.”