Why you should buy garden furniture in the winter, not the summer

Darius McDermott 26/06/2023 in Equities, Income investing

Andy Evans, co-manager of the Schroder Income fund, uses the analogy of buying garden furniture at a discount in the winter, rather than full price in the summer to highlight the patience and contrarian approach of value investors. He also considers the relationship between higher inflation and interest rates and value investing.

We then shift our discussion to the potential for a prolonged period where value companies and industries outperform and look at a variety of sectors including banks, retailers, and house builders. Andy first focuses on banks – their balance sheets and the attractive dividend yields on offer. He then shifts to house builders and explains why these sectors have fallen out of favour and present opportunities for value investors due to concerns such as rising interest rates and cost inflation.

I’m Darius McDermott from FundCalibre and today I’m delighted to be joined by Andy Evans, who is the co-manager on the Elite Rated Schroder Income fund. Andy, good morning.

[00:11] Good morning.

So, I’ve known your team for a very long time, and I understand what value investing is, but for our listeners and watchers of these videos, give us a brief introduction of what your definition of value investing is and how you look for value in a company.

[00:35] Sure. So, at its heart, value investing is really about scouring the market for cheap companies and then buying them for less than their worth. And that sounds incredibly simple when I put it that way, but actually, it’s a lot tougher because often those companies can be out of favour. 

I think, given we are having some very hot weather at this point in time, I’m going to use that as an analogy. So, this weekend the sun was shining, the weather was fantastic, everyone was outside and wanted to enjoy a barbecue and enjoy the sun. A value investor would be out buying their garden furniture and their barbecues in the middle of winter, at the point in time where it’s miserable, it’s cold, no one ever expects the sun to ever shine again. 

And, at points in time, you can look a bit silly. So, you go into B&Q and you walk out with a barbecue under your arm when there’s snow on the ground, even though you’ve got very discounted prices – most people will look at you as though you’re a little bit mad. But I think it’s important, because if you’re patient and you’re willing to buy at those discounted prices, when the sun does shine, as it has done this weekend, value investors can sit there, enjoy the very nice weather, whereas there’ll be other people who have to go down to the garden centre, queue up for their garden furniture, wait in a massive long queue and pay full prices. And that’s really at the heart of value investing: buying when it’s winter and waiting until it’s summer.

Very good analogy, thank you, that’s a nice gentle start. So, one of the factors that has traditionally helped is higher inflation and hence higher interest rates. Why does that help value investing? Why does that help your style of investing?

[02:20] Yeah, I think I’m probably going to approach this from two angles, because I think there’s probably some misconceptions here which we should address as well. 

So, the first point of view is that interest rates and inflation have been viewed as being associated with value in the recent past, for a good reason. And that’s because if you think about the period of very low interest rates that we had, particularly at the back end of the 2010s, that was a period of time where companies which benefited from low interest rates were in favour. And those out of favour companies were those who might actually do better if interest rates were a bit higher, or inflation was a bit higher, so, think about banks or commodity companies and also out of favour companies is where we’re going to be focusing on. And therefore, at that point in time, all the attractive companies would’ve been banks, oil and gas mining companies, those ones that no one wanted to go near; the companies which were going through their winter, coming back to our analogy before. 

And so, there is an element that, because interest rates are now a bit higher than they were before, and inflation is a bit higher than where it was before, that those companies are doing better and they’re the companies that no one wanted a few years ago. But that’s not to say that it is always the case that value is associated with higher interest rates and inflation. I think the more important aspect is really uncertainty. That’s what value investing is really capitalising on. And anytime there is uncertainty, that’s where value investors should be going through those companies which are currently out of favour, working out whether they have the scope to recover. And then waiting until the sun does shine again before enjoying the benefits [ie.] selling those companies and moving on to newer companies.

So, you’ve touched on uncertainty, and we’ve just touched on sort of inflation, maybe a new interest rate environment than the previous decade, which, as you also said, didn’t really favour sort of the style of value investing. Do you think we could be potentially in for a more prolonged period where value companies and value sectors outperform and what’s your outlook for some of the sort of companies that you might own?

[04:31] Yeah, no, sure. So, I think if we look at the situation now, there’s obviously the period of time where value stocks have done a little bit better, so we’ve enjoyed a bit more of a period in the sun. But actually, we should look at it in the context of the period I mentioned before, the 2010s, where low interest rates favoured growth stocks, the companies with their future hopes and expectations and tend to trade on high multiples. 

And one of the ways that we like to look at value and its relative value to growth is just by looking at the average company of the value stocks and saying what do they trade on? And then, what’s the average company which is your growth stock and what sort of multiples do they trade on? And historically we’ve always seen value companies trade at a discount. On average it’s about 40% discount [DM: which you would expect] As you would expect because all the hope and expectations sit inside those growth companies. Value companies are really more focused on being cheap on historical profitability. 

But when we look at that situation, because of the very strong period we had for growth stocks in 2010s, that discount has got even wider, it’s got to a 60% discount. And to put that in the context of history, you’ll have to go back, not even to the dot.com period, but before that, before we’ve seen that elevated level of discount. If we think about the dot.com bubble – so, we’re trading at a bigger discount now than at that point in time – that was really the poster child for a growth stock bubble and, and we know how that ended. 

And so, as value investors, we look at that very, very large discount that we have today – even though value has had a bit of a better time more recently – and say, if that were to go back to more normal levels, that’ll be an incredibly helpful tailwind to value stocks over the coming years.

So, not to put a pun on it, but there’s even more value in the value area of the market.

[06:21] That’s definitely how we feel at this point in time, Darius.

So, let’s now look at a couple of individual sectors. And again, you’ve touched on a few of them, but sectors that are in your portfolio and what appeals at a sector level, what characteristics? I’ve written down banks, retailers, oil companies – maybe there’s one or two of those sectors you’d like to talk about?

I’m particularly interested to hear about banks, given – globally – banks had a bit of a wobble in March stemming from some problems in the US banking system and then that fed into the European banking system with Credit Suisse. How do you feel about those sectors today?

[07:04] Yeah, so let’s start on banks and if you look at the banks as a sector, it’s been a sector that’s been out of favour for a long period of time and therefore it’s appeared in the cheapest part of the market, ever since the financial crisis really. But when we look at the banks, what we see is a series of companies who are in a very different shape than they were before. They’ve come back on the list of concerns because of everything that you’ve mentioned in terms of the banking issues in inside the US. We think actually the banks that we look at in the UK are in a significantly better place than they were going into the financial crisis. 

Let’s look at it from a few different angles. The first would be if you think about their balance sheets. Going into the Global Financial Crisis, they were on very low capital ratios – they didn’t have enough money stored away for a rainy day. Now, they have significantly better balance sheets. The way they lend to the customer is a lot less risky than it was going into the financial crisis. They haven’t been as carried away because of the lessons they’ve learned from that period of time. And actually, because of interest rates going up, we’re actually at a point in time where they’re performing better from an operational perspective; their returns are increasing, their earnings are increasing, and that’s financing dividend yields, which are incredibly attractive. So, that’s incredibly important for our UK income fund that we can find those sorts of companies which are producing very attractive dividend yields. 

The other big benefit is they’re still trading, despite all those things and all those improvements, at a big discount to their book value – they’re trading less than their assets are worth. And therefore we think that if you were to buy the companies today – and the companies are buying back their shares as well – then you’re going to get a very big benefit from that at this point in time. So, I would actually define banks as … companies which aren’t necessarily in their winter at this point in time, but if anything are enjoying slightly better times than they’ve had over the past decade.

And are there any other sectors, retailers or oil? I mean, oil was very topical last year in 2022, but retailers, that sounds like your type of sector; unloved, you know, everybody’s shopping online, nobody goes to stores. Maybe give us a final word then on retailers or so?

[09:19] Yeah, I think I’m going to broaden that out if that’s okay, from retailers to probably more consumer-focused stocks. 

So, if we think about last year and what happened particularly around the time of [former Prime Minister, Liz] Truss being in government, there was a big selloff, particularly in consumer-focused stocks. And you can understand the concerns; cost of living crisis, squeezes on consumer discretionary, but that meant – exactly as you say – the sort of companies which are falling onto our laps at this point in time, are those sorts of companies. They are going through their winter at this point in time. 

I’m actually going to use, rather than retailers, I’m going to use house builders as an example. House builders are companies which actually had a very good period during the 2010s. They enjoyed rising house prices and they made very, very good returns. But obviously with concerns around interest rates rising, they’re a sector which has fallen out to favour and they’ve fallen in terms of share price terms to such a degree, that it’s fallen onto our plates and as value investors, we’re going do our work to look at those companies. 

And what we can see are obviously companies which do have some near-term headwinds. There are going to be issues in terms of the volumes – we can already see volumes have fallen for new houses. There’s concerns around house prices and there’s also concerns around how much your costs [are] to build a house, cost inflation is hitting that as well. And that combination of factors means that these are very much out of favour companies at this point in time. 

But what we see as value investors, are companies which have very, very solid balance sheets, which can weather a tough time, which they may be going through at this point in time. And then we also see very attractive valuations, discounting aggressively the future. And these are important companies for the future we believe of the UK; they’re companies which are going to solve the housing issues or help solve that along with the government. And therefore, we think that the sun will shine for these companies at some point in time. And we just have to be patient and wait for the sun to shine. And that’s the job of the value investor.

Andy, thank you very much. I think that sums things up absolutely perfectly. Now, if you would like more information on the Elite Rated Schroder Income fund, please do visit FundCalibre.com.

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