Predictions that 2017 would be the year that value investing came back into fashion have proven unfounded. Instead, a growth style of investing has continued to outperform, as investors desperate for income focus on bond-proxy companies and technology stocks continue to push global indices higher.
However, Alex Wright, manager of the Morningstar Bronze rated Fidelity Special Situations fund and the Fidelity Special Values IT (FSV), believes it is possible to profit from value investing even in such an adverse environment.
Wright has managed FSV for just over five years, during which time value investing has mostly been out of favour. Still, in both vehicles over that time, Wright has been able to beat both the Morningstar UK Flex-Cap Equity category and the FTSE All-Share index. He gives a couple of recent selling decisions he’s made as examples of why this has been possible.
Despite losing cash investing in Danish cigar maker Scandinavian Tobacco Group (STG) Wright says his loss was limited to around 7% due to the valuation being extremely low compared to peers when he bought in.
His foray into Spirent Communications (SPT) has also not worked out as expected due to top-line growth weakening thanks to tough conditions in markets such as ethernet testing. Spirent’s offset that by cutting costs and improving margins and “we’ve made money on that position because the valuation was so low”, explains Wright.
Across the market, valuations are currently tipping towards the expensive side, but Wright says he is still finding ample opportunity to invest in undervalued stocks. He currently owns 14 companies that that trade below book value, which he says is “pretty rare”. He outlines three for us here.
International Personal Finance (IPF)
Since trading at a peak of 683p four years ago, home credit firm IPF has lost 70% of its market value. As a result, at 200p currently, it’s trading at 0.9 times book value. That’s despite high return on equity of around 14% in the current financial year.
The share price slump is due to regulation in Poland, its largest market, that proposes capping fees lenders can levy. Being a high APR lender, this would be negative for IPF. The second proposal, made in December, saw IPF’s market cap halve.
But this cap has still not yet been enacted and Wright says there are now doubts it will come to fruition. Further, IPF was able to close its business in Slovakia and recoup its outstanding loan book within 18 months of a more penal cap being imposed there.
While it would be a much bigger deal should IPF have to close its Polish business – which is around 10 times bigger than in Slovakia – Wright predicts they would be able to do similar there and be able to repay both bond and shareholders.
Therefore, he says, “in a worst-case scenario you get your money back”. However, “if the cap is either enacted as is and they are still able to lend, or the cap comes in at a higher level than is proposed, there could be significant upside”.
Millennium & Copthorne (MLC)
Earlier this month, hotel operator Millennium & Copthorne agreed to a buyout offer of 545p per share with its largest shareholder, Singapore-based property developer City Developments. CDL now has until Monday 6 November to make a firm offer.
However, Wright and other minority shareholders have spoken out against the deal, claiming it “significantly undervalues the company”. That’s because MLC currently trades on 0.7 times book value, which is the level at which the offer was made.
Wright says that, while an “extremely poor” RoE of 4% is the main reason why MLC’s valuation is so low, the last time its book value was fully assessed was in 2003. “Since then, assets in central London and central New York have gone up in value quite a lot so it could be significantly more below book value than that 0.7 times suggest.”
Wright says that MLC “shows where there are these corporate governance uncertainties [and] poor current returns you can buy assets significantly below their true worth”.
Royal Bank of Scotland (RBS)
Financials is currently Wright’s favoured sector. Special Situations has around 37% of its portfolio invested in financials. Citigroup is its largest bet, but other banks also make a prominent appearance. RBS was a recent acquisition at 0.9 times book value.
Previously a high return company, its troubles since the financial crisis are well documented. Indeed, the UK Government still owns 71% of the stock. Clearly, there’s plenty of uncertainty around its restructuring.
The biggest unknown is a potentially huge fine from the US Department of Justice over mortgage-backed securities mis-selling claims. While Wright’s base case is a $9 billion fine, which would be one of the largest in corporate history, he says RBS would still have “very significant excess capital after paying that”.
“Once that’s sorted, they can get back to paying dividends and, importantly, also doing buybacks, which would further enhance their returns and are clearly very accretive at a price below book value.”
Achieving a return on equity target over the next three years of 12%, currently 8.5%, would also be a boon, and “that doesn’t rely on any revenue growth, it just relies on continued cost cutting and business process re-engineering”.
While Morningstar analyst Derya Guzel agrees that resolving RBS's litigation and conduct issues will be a big step for the bank, she says those problems have the potential to create earnings volatility.
