Samantha Gleave

Value in a modern economy

Samantha Gleave

Value investing has had an extremely poor run over the last few years, and the coronavirus crisis has only exacerbated this trend. This has raised questions over whether value is structurally impaired or if different measures of value are required for a modern economy, which we address in this article.

 

A loose definition of a value stock is one which is trading on cheaper multiples of its own fundamentals (e.g. profits, book value, sales) compared to the rest of the market. This gap in valuation could be present for a number of reasons, but for a value investor it is there because the market underappreciates the business and is  indicative of a potentially significant share price correction once the true value of the company is realised.

 

The coronavirus pandemic saw value stocks’ underperformance versus their growth counterparts widen even further. To demonstrate this, the following chart plots the performance of the MSCI Europe ex-UK Value Index relative to the MSCI Europe ex-UK Growth Index over the last 15 years.

 

Value vs growth - Europe ex UK

 

The story is similar for stocks in the UK and US. It has led to arguments suggesting that value is structurally impaired, given the extent of central bank stimulus keeping bond yields at all-time lows and the knock-on impact these low yields have for the valuation of companies expected to grow earnings: lower yields mean a lower discount rate in investment models and higher present value for earnings delivered in the future.

 

Furthermore, the technological revolution may leave traditional valuations based around tangible assets such as buildings, equipment and land as obsolete.

 

Style Analytics, the portfolio insights company, argued that the measurement of valueness should be reconsidered [1]. The price-to-book ratio is the standard measure of used by investors, but this is outdated given the construct of the modern company. They argue that intangible assets are an important component and looking purely at book value ignores the role they play. Intangible assets are seen as yielding assets, in a similar way to tangible assets, and research and development expenditure should be seen as a way of maintaining the intangible asset base.

 

To more accurately measure the impact of intangibles, the researchers suggest using free cash flow yields. The idea behind this is that cash flow will more accurately reflect the effectiveness of companies’ assets – both tangible and intangible.

 

This focus on free cash flow yields is obviously in keeping with the core elements of our investment process: As the name suggests, the Cashflow Solution process focuses on company cash flow, which we believe is a more reliable guide to future profitability and stock price valuation in the medium term. We analyse our investment universe using the cash flow to operating assets and cash flow to market value ratios. These ratios have been developed over a number of years and contain our own proprietary definitions of operating assets and cyclically-adjusted, normalised cash flow.

 

However, others argue that traditional measures of value are not yet dead. A recent paper by research affiliates [2], which ran a model decomposing the total returns of a value and growth portfolio, found no evidence to suggest value has been structurally impaired. It stated that the underperformance of value verses growth since 2007 has been driven almost entirely by changes in relative valuations, which they claim should revert to zero in the long-run. This is an argument supported by renowned hedge fund investor Cliff Asness, who believes that value’s poor run has been less to do with a deterioration in fundamentals and is largely just price movements.

 

Whichever side of this argument you come down on, we feel that our investment process captures the best opportunities in traditional value stocks as well as those that are more typical of the modern economy. While all our stocks must score highly on their free cash flow characteristics, our process employs additional secondary scores that attempt to highlight opportunities for different styles and strategies such as growth, cash return, recovering value and contrarian. We recently wrote about how our process has signalled an opportunity in value.

 

Our measures of value spread currently remain wide and a theme that has appeared in our recent annual review of companies’ report and accounts has been the large number of stocks in the top quintile (Q1) of our cash flow screens with really attractive high free cash flow yields.

 

Valuation of factors

 

Perhaps unsurprisingly, the sectors which have appeared the most attractive are among those that have been among the hardest hit by the pandemic. We have found stocks in the auto sector, retail and banking trading at a particularly high discount when measured using multiples of their adjusted free cash flows. These are the areas which we think could see a significant bounce back in share prices if, as we expect, the valuation gap between value and growth closes.


[1] “Re-identifying the Value Factor”, Style Analytics

[2] “Is Value Investing Structurally Impaired?”, research affiliates

Liontrust Insights

 

For a comprehensive list of common financial words and terms, see our glossary here.

 

Key Risks

Past performance is not a guide to future performance. Do remember that the value of an investment and the income generated from them can fall as well as rise and is not guaranteed, therefore, you may not get back the amount originally invested and potentially risk total loss of capital. Investment in Funds managed by the Cashflow Solution team involves foreign currencies and may be subject to fluctuations in value due to movements in exchange rates. The Liontrust European Growth Fund holds a concentrated portfolio of stocks, if the price of one of these stocks should move significantly, this may have a notable effect on the value of the respective portfolio. The Liontrust Global Income Fund's expenses are charged to capital. This has the effect of increasing dividends while constraining capital appreciation. 

Disclaimer

The information and opinions provided should not be construed as advice for investment in any product or security mentioned, an offer to buy or sell units/shares of Funds mentioned, or a solicitation to purchase securities in any company or investment product. Always research your own investments and (if you are not a professional or a financial adviser) consult suitability with a regulated financial adviser before investing.

Thursday, September 17, 2020, 9:15 AM