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Are Value Stocks Good Value?

Value stocks are cheap, but investors need to be wary of the difference between a value trap and a true investment opportunity

Cherry Reynard 20 August, 2019 | 12:34PM

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These are perilous times for fund managers with a value investment style. While on most measures, "value" stocks look lowly rated relative to growth stocks and to their own history, the penalties for getting it wrong are higher than ever. Recent research by EY showed profit warnings for UK quoted companies are at their highest level since the global financial crisis. 

A recent report issued by the BlackRock smaller companies team issued a stark warning: “The market needs to fundamentally reappraise the true value of over-indebted, structurally challenged business models, particularly those that are paying dividends they can’t afford. We think there are many of these companies out there masquerading as “cheap shares” because their “price to adjusted earnings ratio” looks low, and for too long other market participants have championed some of these shares as “value” investments.”

But how can investors ensure they are getting "real" value, rather than paying for optically cheap stocks that will continue to get cheaper? 

David Keir, co-manager of the two-star rated TB Saracen Global Income & Growth fund, says value is a winning style and has outperformed over the long-term, but has been struggling during the quantitative easing era of the last ten years. Value is now cheaper than it has ever been, but companies that fail to deliver on earnings are being more harshly treated by the market.

For him, the most important element is whether a company can grow: “There are many cheap shares in the value bucket, but ultimately if they are in long term decline, it doesn’t matter how cheap they are, they’re a bad place to be.”

He looks at five major reasons why a company might see a savage de-rating that are incorporated into the group’s process: a sudden decline in revenue growth; structural issues affecting the sector; a declining margin profile; a weakened balance sheet or high debt; and finally, badly thought-out merger and acquisition activity.

Neil Veitch, manager of the three-star rated SVM UK Opportunities fund, says: “Like an evil doppelganger, ‘value traps’ often look exactly like those stocks which offer genuine value... it relies upon investors having a deep understanding of companies and the sectors in which they operate.” He is particularly wary of businesses in sectors that have been disrupted by technological advances or long-term changes in consumer behaviour - the retail sector, for example.

Andrew Jackson, manager of the LF Miton UK Value Opportunities fund, which also has a three-star rating from Morningstar, says successful value investing relies on companies returning to normalised profitability. As such, if the improvements in operating performance prove beyond the grasp of the company, leading to further disappointment and another episode of renewal and planning for recovery, investors may be in trouble.

Part of the issue is spotting whether problems are permanent or temporary. Tom Wildgoose, co-manager of the five-star rated Nomura Global High Conviction Fund “The value of a company depends on the cash flow it will generate in the future and the shares of a company are only ‘cheap’ if the share price under values those future cash flows. Some companies have cyclically low or temporarily impaired cash flows, meaning that the cash presently being generated is not representative of the cash that will be generated in the future. Others face permanent impairment to their future cash flow generation capability.”

For him, the difference may be between a company experiencing a cyclical shift in their earnings, and one that is threatened by a permanent change in their fortunes. He considers the company’s competitive advantages, the return on capital it generates and the long term opportunities for reinvestment, the skill of the management and the consistency of the return of cash to shareholders as the important factors, plus the capability to "weather a storm".

Where are the weak spots today? Unsurprisingly, most identify the retail sector as a "value trap", Jackson says: “Right now, the retail sector is fascinating, as long-established brands with thousands of square feet in high profile locations face competition from both discounters and the internet start-ups.  The chasm in prices is so large that old play books of simply cutting prices has been insufficient to recapture sales.”

Veitch adds: “While these stocks may trade on depressed P/E ratios or significant discounts to their stated net asset value, they certainly reek of ‘trap’.” However, he believes that investors must also be wary of seeing disruption where it doesn’t exist. He points out that while electric vehicles, autonomous driving, and ride-sharing are all exciting developments, the timing and magnitude of their impact on the automotive sector and its supply chain remains uncertain. In this case, certain cyclical headwinds are being mistaken for something more structural.

Ultimately, companies aren’t "value" just because they are cheap. Companies in structural decline are being dealt with more harshly than ever before. It is more important than ever to be able to tell the difference between value and value traps.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author

Cherry Reynard

Cherry Reynard  is a financial journalist writing for Morningstar.co.uk.

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