Value investing is the art of buying companies for less than their intrinsic value. It is Warren Buffet’s favoured method of stock selection – and when done successfully can guarantee double digit returns over decades.
“I suppose all fund managers say that buy stocks that are worth more than they pay for them,” said Nick Kirrage, manager of the Morningstar Analyst Silver Rated Schroder Recovery fund.
“But with value investing, we have a more kind of disciplined way of identifying those companies, of finding businesses that trade explicitly low valuations, low P/Es, low cyclically adjusted P/Es, valuation metrics, and we fish in particular ponds of cheap stocks.”
Kirrage and his co-manager Kevin Murphy follow principles of the original value investor Benjamin Graham, who published a book on value investing in 1934, and is known as Warren Buffett’s mentor.
Graham created a method of valuing stocks that he claimed would identify those companies that would deliver returns of up to 10% a year for a decade.
Stock selectors will be familiar with price to earnings ratios (often abbreviated to P/E). This ratio is calculated by dividing the current share price by the earning per share, and is a way to determine whether a stock is cheap or expensive based on earnings stream. Generally speaking, the lower the number, the cheaper the stock – although there are exceptions to the rule.
The Graham & Dodd P/E uses the average earnings over the previous 10 years, meaning you are less likely to have an anomaly distort the P/E figure. Historical data shows a correlation between the Graham & Dodd P/E and future returns. According to data correlated by Kirrage and Murphy equities with a Graham & Dodd P/E of between five and 10 have an average annual return of 11% for the decade following valuation.
It is a style that can have periods of underperformance however – as some stocks are cheap for a reason. Tom Dobell’s M&G Recovery fund has earned a Morningstar Analyst Gold Rating for stellar past performance and a style analysts have a high conviction in. But recent returns have been extremely disappointing – earning him a downgrade from some rating agencies and an appearance on BestInvest’s Dog list of funds-to-sell.
“Despite the weak near-term performance, we retain our conviction,” said Morningstar analyst Chetan Modi. “This fund’s relative performance has undoubtedly disappointed investors in recent years. In the three years to the end of Feb 2014, the fund has lagged the FTSE All-Share benchmark by 3.3 percentage points per annum and has trailed the category by a more significant 7.6 percentage points per annum.
“While that is an unsatisfactory outcome for investors, the fund is still ahead of the benchmark and category since manager Tom Dobell took charge at the end of March 2000.”
Rathbone Recovery, run by Julian Chillingworth is another fund which aims to invest in stocks that are not fairly valued by the stock market, and exploit this undervaluation.
The fund returned an impressive 36% last year – as exposure to mid and small caps boosted performance.
What Stocks are in Value Funds?
Between the three funds there are several stocks that appear in every portfolio. Using the Morningstar Portfolio tab, we created a portfolio made up of the three recovery funds equally weighted. Then using the X-Ray tool we revealed the top five underlying holdings of this value portfolio.
BP (BP.) 3.49% weighting, held by M&G Recovery and Schroders Recovery
GlaxoSmithKline (GSK) 2.46% weighting, held by M&G and Schroders
Lloyds (LLOY) 2.04% weighting, held by M&G and Schroders
Royal Bank of Scotland (RBS) 1.7% weighting, held by Schroders and M&G
