When it comes to growth companies, investors are typically over-optimistic, and the reverse is also true: investors tend to be over-pessimistic about value companies—extrapolating weak earnings trends too far ahead in the process.
History shows that the differences in growth rates between “glamour” and value companies do not persist. In fact, the growth rates of value companies tend to improve as companies divest underperforming assets, bring in new management and emulate competitors.
In the long run, from a behavioural point of view, it is much easier to buy seemingly safer glamour stocks and to shun slower-growing value stocks with less promising prospects—and investors are generally more comfortable with this approach too.
Finding out-of-fashion stocks which are fundamentally sound
So what are value investors actually looking for? Essentially, they’re looking to invest in out-of-fashion, cheap stocks that are fundamentally sound.
A prime example at the moment is Imperial Brands—a name that has been unloved and out of fashion for obvious reasons. There are 1.1 billion smokers in the world, but this number is falling quickly and the many alternatives are winning market share.
This negative sentiment towards Imperial Brands has been reflected in the stock’s valuation, which fell to a low of less than 9x P/E in April of this year—the lowest it has been in the last 15 years. However, we’d argue that this is a classic case of the market becoming too pessimistic on the outlook for the company because almost exactly at the same time as this extreme valuation occurring, the company announced better-than-expected profits for the first half. Expectations had simply become too low and led analysts to upgrade their forecasts for the first time in almost two years.
The difficulty lies in ensuring that a stock is not cheap for a reason i.e. a value trap. These value traps are those companies that look cheap but actually have the potential to disappoint further. This can be due to issues within the company itself or factors out of the company’s control.
Why portfolio construction counts
Portfolio construction might not be the sexiest part of fund management, but it’s an area that we believe is just as important as stock selection—and one that’s underestimated by many in the market. Style purity is key here, so we don’t buy any stock that we deem to be either too expensive or value traps, regardless of its index weightings.
For stocks that we do like, we own them to equal positive active positions versus our benchmark. This helps to create a very diversified portfolio, and one within which we are trying to maximise our exposure to the value style, but minimise stock-specific risk. The only restriction we impose is at the sector level where we cannot be more than 10% overweight a sector: we don’t want this to be a closet theme fund.
Why value investing is working now
Unlike growth investing, value investing tends to work when the yield curve is steepening and/or inflation is picking up. This is largely because financials—a hefty portion of most value indices—benefit from this situation via higher net interest margins (banks) and investment income (insurance). The future shape of the yield curve remains unclear, but yields have been recently been moving up, and any continuation of this will be a positive for the value style.
Value investing also tends to work when investors are feeling more optimistic about the economy: in this situation, where growth is more assured across the market, the focus becomes much more about buying cheap stocks. Against a backdrop of uncertainty around Brexit negotiations and a potential escalation in trade wars, this isn’t necessarily the situation we find ourselves in today. But this can change quickly; for example, if a Brexit deal were to be finalised sooner than expected.
What does give us cause for optimism is the fact that value dispersion is currently wide. Value performs best when the gap between the cheapest and most expensive stocks in the market is wide: think of an elastic band being stretched and once the catalyst arrives the returns to value are dramatic, much like what we saw when the tech bubble burst in the early 2000s.
Today, value spreads in the UK are in the widest quintile relative to history. In Europe, the situation is even more extreme: value spreads are in the widest decile versus history and crucially this is the case both between and within sectors. So not only is there a wide gap between cheap sectors such as mining and expensive sectors like media, but there are cheap and expensive stocks within both sectors as well. So future returns to value can be driven by both the narrowing of the value gaps between sectors, but also within sectors.
Ian Butler is portfolio manager of the JPM UK Strategic Equity Income Fund within J.P. Morgan Asset Management's UK Equity team. Read more about the fund>
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