The resurgence of value investing

Juliet Schooling Latter 24/04/2024 in Equities

Growth stocks – and the technology mega-caps in particular – have continued to defy gravity in 2024. Nevertheless, some cracks have started to appear in high-profile growth companies such as Tesla and Apple, and even the semiconductor giants TSMC and ASML have wobbled. It is increasingly clear that embedded expectations may be too high. After a long time out of the limelight, patient value managers may finally get their moment. 

It has been a tough run for value managers. Over the past decade, the MSCI World Value index has delivered an annualised return of 7.25%, compared with 9.97% for the broader MSCI World index*. This weakness had been attributed to the low interest rate environment that prevailed after the global financial crisis – and more recently because of the excitement around artificial intelligence. However, it has continued even as interest rates have risen over the past 12 months, with the value index trailing by around 6%*.

Ben Arnold, investment director on the Schroders value team, which runs the Elite Rated Schroder Recovery and Schroder Income funds, believes this has left a fertile environment for value managers. He says: “Winding back to before Covid, the opportunity set was very narrow, focused largely on oil and gas, mining and banks. Those three sectors dominated our portfolios, holding as much as 50%. We still hear the argument that this is where value managers are focused, but it’s a very dated view. Over the past few years there has been a huge broadening out. Our portfolios are now cheap, but they are also super diverse.”

He says the team is even finding opportunities in traditional ‘growth’ areas, such as the US and smaller companies. While the aggregate valuation of the US market looks high, the mega-caps skew those valuations, and further down the market capitalisation scale (the likes of mid and small-caps), the market looks attractive.  

Ben says that the team is running the highest allocation to small and mid-cap businesses than ever before. He says: “Small and mid-cap valuations are very depressed. We know smaller companies tend to outperform over the longer term, yet the trend over the past few years is that large has outperformed small. As such, our eyes are drawn to smaller and mid-sized businesses and this is a key theme across all our strategies.” 

When will value revive?

The question for value managers is when market leadership might shift. In the very short term, mega-cap technology companies, such as Tesla, Apple, TSMC and even stock market darling Nvidia, are having a tougher time. Value tends to do better in an environment of higher interest rates, so the paring back of rate cut expectations should be supportive. Equally, valuations for value versus growth continued to look polarised relative to history.

However, Ben says searching for the turning point may be fruitless. He adds: “When sectors and countries are trading very cheaply, the question is often ‘what is the catalyst?’, ‘Where is the marginal buyer?’ Our view is that valuation in itself is a catalyst. Things just get really cheap, and at some point, things mean-revert. Working out the catalyst is a fool’s game. If investors knew what the catalyst was, the shares wouldn’t be that cheap.”

Ben says that they are focused on what they can control. He says that for the companies in their portfolios, fundamentals are at odds with what people are willing to pay for them: “At some point, over 3-5 years, that will improve, but whether it’s tomorrow or in five years, we don’t know.”

Increased M&A activity

That said, there are a few factors that could help realise value in some unloved parts of the market. M&A activity is picking up, particularly in unfashionable markets such as the UK, where there have been bids for high-profile companies such as Currys and Direct Line. There is growing bid interest in the UK from US private equity groups. This is also a phenomenon in Europe, where valuations are similarly cheap.

There has also been a significant expansion in buybacks, particularly in the UK market. Ben says that the running yield – which aggregates dividend yield and buyback yield – is significantly higher today than it has been for some time. Importantly, buybacks are not happening at the expense of the business. In general, the companies they hold are generating a lot of capital, and this is allowing them to buy back their shares.

A final consideration is that the cheapest companies are, in some cases, growing their earnings faster than growth companies. This isn’t true in the US, where higher valuation businesses have also delivered higher earnings growth, but is true in Europe. He says: “European growth companies have delivered less profit growth than the cheaper companies. That’s really surprising and has driven a lot of disconnect in the valuations. It is a phenomenon that is going below the radar.”

To its credit, the Schroders value team hasn’t necessarily needed value to do well to boost fund performance. Over three years, the Schroder Income fund is up 33%, against the IA UK Equity Income sector average of 17.6%**. Similarly, the Schroder Recovery fund is up 25%, against the IA UK All Companies average of 7.6%**. Careful stock selection to avoid ‘value traps’ – those companies that are optically cheap, but have further to fall – has been crucial in this outperformance.

“If you’re buying a company trading on a low valuation, it is so important to do a lot of bottom-up analysis. Simply buying cheap companies passively and expecting them to re-rate is not going to help an investor avoid the value traps. We have to try and weed out the weaker ones.”

It is also important to note, he says, that even if the value/growth elastic looks very stretched, there has never been a time when markets are brilliantly rational. It is their irrationality that provides the opportunity for value investors. Nevertheless, investors fretting about the wobble in US growth stocks could do worse than explore some of the top-performing value funds to rebalance their portfolios in preparation for tougher times ahead.

Alternative offerings to consider for value investors

ES R&M UK Recovery

Hugh Sergeant holds approximately 200 of these out-of-favour stocks in the portfolio. The investment team has a bespoke philosophy and process called ‘PVT’: potential, value and timing. It has a quantitative process that underpins all investment choices.

Fidelity Special Values 

Manager Alex Wright looks for stocks that are out-of-favour, but that must meet two strict criteria. The first is the preservation of investors’ capital: this is by targeting companies with exceptionally cheap valuations or an asset, such as intellectual property or inventory, which has the potential to limit share price falls. Secondly, he looks for companies where there is a catalyst for significant earnings growth.

IFSL Wise Multi-Asset Growth

This fund invest in around 30-60 underlying funds and investment trusts, with a preference for out-of-favour areas. Specialist trusts have been a big part of the portfolio with holdings in the likes of infrastructure, private equity and biotechnology.

*Source: MSCI index factsheet, 29 March 2024

**Source: FE Analytics, total returns in pounds sterling, 23 April 2021 to 23 April 2024

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