This article is part of Morningstar's "Perspectives" series, written by third-party contributors. Here Schroders fund manager Nick Kirrage urges investors to consider old-fashioned "value" investing if they want to make the most of future returns. It is part of Morningstar’s Guide to Your Financial Education, providing our readers with the tools they need to become a successful private investor.
One of the first things retail investors in the US ask themselves when they decide to make an investment is, ‘do I want a value or a growth investment strategy?’ Incredibly, this concept doesn’t really exist in the minds of investors in the UK, even though the choice between value and growth is so critical in determining the best strategy to meet investment objectives.
Value investing in the UK tends to be a niche strategy often overlooked for all the wrong reasons. We believe that when it comes to value investing good things come to those who wait – it is an incredibly powerful strategy, with incredibly strong long-term returns.
What is Value Investing?
Value investing is as the art of buying stocks which trade at a significant discount to their intrinsic value. Value investors achieve this by looking for companies on cheap valuation metrics, typically low multiples of their profits or assets, for reasons which are not justified over the longer term. This approach requires a contrarian mindset and a long term investment horizon. Over the last 100 years a value investment strategy has a consistent history of outperforming index returns across multiple equity markets.
There are many reasons why a stock might trade at a discount to its intrinsic worth; however, the most common reason is short term profit disappointment, which often results in a substantial share price fall. Frequently these disappointments can produce a strong emotional reaction in shareholders who sell their stock fearing further negative developments. Value investors recognise two things. Firstly, most businesses are long term in nature and the real affect of short term profit falls on the long term value of a business is often small. Secondly they recognise that, on average, most company profits are mean reverting over time. i.e. over the longer term, disastrous profit falls are frequently reversed and conversely, extremely strong profit growth tends to slow.
This is a remarkably powerful fact and often not easy to believe. The reason is that there are so many high profile examples of it not being true! Enron, Worldcom & Lehman Brothers have all seen profit declines in the past that did not bounce back - neither did their share prices. Conversely, Microsoft and Amazon are two businesses where profits have risen steadily since their inception and show no signs of falling back to an average any time soon. However, as humans, high profile examples tend to stick in our minds, even if they are not reflective of what happens on average.
Value investing seeks to exploit the irrational behavior of emotional investors. Emotion is a constant feature of investment markets through time and whilst the companies available to stock market investors change from decade to decade, the human nature of the investors themselves doesn’t. Fear and greed remain ever present and frequently lead to poor investment decisions based on perception and emotion rather than reality. Periodically these mispricings can become extreme for example the tech bubble of the 1990s or, conversely, the great depression of the 1930s, however, they exist to a greater or lesser extent in most markets. This creates an opportunity for dispassionate, long term value investors. Though this concept seems simple, sensible and, hopefully, appealing, it is much easier to say than do in practice.
Value investing is not always in favour and does not always outperform over shorter time periods. In the short term the market is a voting machine, whilst over the longer term it tends to be a weighing machine. Over the last 100 years there have been many periods where buying cheap stocks has not been a short term vote winner and instead other investments have been the darlings of the day. These periods may last for some years during which time value investors are made to look foolish and are dismissed as being out of touch. This is psychologically arduous for both fund managers and their clients alike and requires a balance of humility and fortitude. However, despite this the long term results from this approach are extremely attractive – seldom are the best things easy.
The proof…
There are many ways to highlight that a value investment strategy outperforms over the longer term. The chart below highlights the outperformance of buying the highest dividend yield stocks in the UK market over the last 100 years. High dividend yield stocks are considered value investments as their higher yield is typically a reflection of the fact their share price has fallen (the yield is simply the dividend the company pays divided by the share price). The chart shows that by investing in the cheapest parts of the market you would have dramatically outperformed lower yielding stocks and the market as a whole.
