In association with
The adviser’s guide to value investing
Chapter 1
The great rotation: from growth to value
Chapter 2
Diversification, diversification, diversification
Chapter 3
Case study: taking advantage of undervalued stocks
Video
Is choosing value a trade-off?
Podcast
How can value investors make an impact?
Key takeaways
With a decade of quantitative easing set to be ending, interest rates rising and inflation surging, investors should expect a prolonged rotation from growth to value stocks. From a country perspective, in a yield-starved world the UK still offers investors one of the highest yields of all international markets. Royal Mail stock example: “In the case of Royal Mail, the company’s £4.5bn market capitalisation is accounted for entirely by its overseas operation, meaning its UK business is in the valuation for free.”
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Despite signs of a rotation from growth to value stocks, investors piled £12bn into global equity funds in 2021 as technology and growth stocks continued to perform strongly.
On the flip side, Global Equity Income Fund inflows were broadly flat for the year, while the IA UK Equity Income sector sat bottom of the charts with outflows of £3.28bn. However, with a decade of quantitative easing set to be ending, interest rates rising and inflation surging, Ian Lance, co-manager of the TM Redwheel UK Equity Income Fund, says investors should expect a prolonged rotation from growth to value stocks going forward. “The last decade has been extraordinary in terms of monetary stimulus,” says Lance. “However, putting this into context, the past 18 months have also been incredible. In this time, the Federal Reserve’s balance sheet has increased by $4trn, which previously would have taken them more than a century in terms of expansion.” Lance says this has created an “absolutely extraordinary” environment for growth stocks in particular, with the Nasdaq Index rising 100% between March 2020 to March 2021. Over the same time period, Tesla’s share price rose 1,200%. “There is some suggestion there is bubble-like activity,” says Lance. “However, our contention is that inflation may be bringing this to an end.” After much debate last year as to whether inflationary was transitory, Lance says an examination of the numbers – with US inflation currently at its highest level in four decades and in Europe at a 30-year high – would suggest it is not transitory. “For a while many thought the central bank would stand back and do nothing, but after the Fed came out last year and stated they may raise rates more than previously expected and shrink the size of their balance sheet, there was a rapid change in market sentiment.” The result is that at the start of 2022, Lance says it feels like a rotation has started to take place with nearly 40% of the Nasdaq constituents losing half of their value since the peak. “What is interesting is that at the start of this year this has started to spread to some of the larger companies, with Microsoft, Amazon and Netflix all down,” he says. As a result, Lance notes it might be time for investors to start considering diversifying into value. “It has been a frustrating period of time for value managers,” he says. “It has felt as if nobody has cared about valuations or fundamentals while the central banks were flooding the market with liquidity. But we do think this is changing.” So where are Lance and his co-manager Nick Purves currently finding the most value? “Relative to their own history, it is a lot of the classic value sectors that look very cheap,” says Lance. “Areas such as energy, industrials, telecoms, materials and banks are not only cheap, but they also are providing the greatest earnings growth and earnings upgrades.” From a country perspective, he adds that in a yield-starved world the UK still offers investors one of the highest yields of all international markets. To pick some stock examples, Purves highlights the case for Royal Mail and Royal Dutch Shell. “What these companies have in common is that a large part of their business is effectively in the valuation for free because the neglect surrounding their share price has been so great,” says Purves. “In the case of Royal Mail, the company’s £4.5bn market capitalisation is accounted for entirely by its overseas operation, meaning its UK business is in the valuation for free.” In a recent trading statement, Royal Mail said its UK business for the year to March 2022 is set to deliver £500m of operating profit, which Purves believes could result in a doubling of its share price. “We have been through a long period where it has all been about liquidity, and valuations haven’t been important to investors,” concludes Purves. “This is despite the fact there is much evidence to show that over the long term, starting valuation is the best determinant of subsequent investment return. “What we want to highlight is the idea that given these changing conditions in the market, we are on the cusp of seeing some quite significant regime change in which valuations – which look attractive in both a relative and absolute sense – come to the fore.”
No investment strategy or risk management technique can guarantee returns or eliminate risks in any market environment. Past performance is not a guide to future results. The prices of investments and income from them may fall as well as rise and an investor’s investment is subject to potential loss, in whole or in part. Forecasts and estimates are based upon subjective assumptions about circumstances and events that may not yet have taken place and may never do so.
Disclaimer:
‘It has felt as if nobody has cared about valuations or fundamentals while the central banks were flooding the market with liquidity. But we do think this is changing’
co-manager, TM Redwheel UK Equity Income Fund
Ian Lance,
Back to home
Many investors who have portfolios full of growth and technology stocks are now rapidly realising they do not have as much diversification as they previously thought. For those investors who are either beginning to, or are considering increasing their exposure to value, the UK equity market is a good starting point. UK correlates strongly with global value and the UK often outperforms during risk-off periods. It tends to be a relatively defensive market and is a beneficiary of higher yields, while starting valuations today remain low.
Investors who have turned their backs on UK equity income funds have been warned their investments may be much less diverse than they expect
To highlight the unpopularity of UK dividend-paying stocks, the sector saw outflows every single month last year as investors were more attracted to the lure of global funds. Ryan Hughes, head of investment research at AJ Bell Investments, notes that it is little surprise UK equity funds have had a poor year as investors typically shun areas that are having a tough time. The worry for Hughes is there be many investors who have portfolios full of growth and technology stocks who are now rapidly realising they do not have as much diversification as they previously thought. “Right now, oils, miners, banks and other cyclicals that make up much of the UK stock market look pretty appealing in a world of rising interest rates, but many investors are still significantly underweight,” he says. For Hughes, this comes back to the basics of portfolio construction and understanding style and diversification. “The benefits of having exposure to the unfashionable areas of the market are now being seen but, as is often the case, investors are slow to wake up to this and end up buying high and selling low,” he says. Ian Lance, co-manager of TM Redwheel UK Equity Income Fund, says it may surprise some investors that the best-performing sectors over the past 12 months have been energy and financials. “Financials, energy, industrials and materials all tend to do well when yields are rising, while sectors like consumer staples and utilities tend to do quite badly,” he says. “So it does look like the stock market is already starting to favour some of the value sectors.” As a result, for those investors who are either starting to, or are considering increasing their exposure to value, Lance says the UK equity market is a good starting point. “There are three things that are in favour of the UK,” he says. “Firstly the UK correlates very strongly with global value. Secondly, recent research from Morgan Stanley also shows how the UK tends to outperform during risk-off periods, while thirdly it tends to be a relatively defensive market and is a beneficiary of higher yields.” Another factor in favour of the UK, he adds, is that starting valuations today are very low. “Relative to the MSCI World Index the FTSE is trading at about a 45% discount, which is much larger than its average discount of about 17% over the last decade,” he says. Breaking the UK down, Lance says while small and mid-cap sized companies look quite expensive, the team is currently finding most value within the large-cap area of the market. “Deal activity has picked up significantly in the UK because lots of companies look cheap in absolute terms and therefore they have been targeted for private equity,” he says. “If we drill down and look within the UK market, what we can see is that the value is really in the large companies and it’s a lot of the classic value sectors that look very cheap.” On top of this, in a yield-starved world the UK still offers one of the highest yields of all international markets. So will this be enough to tempt investors away from the lure of growth and tech? “Many industries go through longs periods of feast and famine and downturns occur when companies are unable to match the high expectations of investors,” says co-manager Nick Purves. “As expectations are not met the valuations then reduce to the extent that the capital invested in the industry ultimately becomes undervalued, at which point capital starts to depart.” This is what is known as the capital cycle, and in this phase while share prices underperform, Purves adds it also sows the seeds for a subsequent upturn. “What we are looking for is industries – such as energy and mining – where we see scarcity today because of where they are in the capital cycle. They have been starved of capital and as a result could be set for the next upswing.”
‘We are looking for industries – such as energy and mining – where we see scarcity today. They have been starved of capital and could be set for the next upswing’
Nick Purves,
Sentiment towards a company sometimes becomes so negative that you can buy a business where one part of it is worth more than the valuation of the entire group. The market is undervaluing Marks & Spencer’s clothing and home business, which Ian Lance believes should be valued closer to £3bn. If added on to today’s share price this would provide an upside of 80%. The Redwheel UK Value team are long-term intrinsic value investors who use these overreactions by market participants to purchase stocks at less than their true value.
Buying shares at a discount to their intrinsic value builds in a margin of safety but also offers attractive total return potential through both dividend and capital appreciation
In May 2020, as the world was in the early stages of the Covid pandemic, Ian Lance, co-manager of the TM Redwheel UK Equity Income Fund, argued that some UK stocks were so cheap that just one division was worth more than the value of the entire group. Lance says some of the Redwheel value team’s most successful investments have been those in which sentiment towards a company becomes so negative that the valuation ends up making no sense versus the worth of its various parts. “Sometimes this is so extreme that you can buy a business where one part of it is worth more than the valuation of the entire group and so, in effect, you are getting the other parts ‘for free’,” says Lance. One example Lance picked out as being an investment opportunity on this basis was Marks & Spencer. His thesis was that the market was ascribing no value to the UK retailer’s clothing and home business, if a reasonable value was placed on its food operation and the company’s stake in Ocado. “Since our original blog the share price has risen by 145%, and while the market has belatedly begun to recognise the transformation going on within the company, we would still argue it is not ascribing full value to the assets,” says Lance. Breaking down the numbers, he explains the current enterprise value of M&S is £5.6bn, or £4.1bn once the value of its stake in Ocado (estimated to be £1.5bn) is deducted. Elsewhere the company’s food business is forecast to make about £280m of operating profit this year, which would make it worth £2.9bn, while Lance says its international business could be worth £1.1bn. “Deducting these we can estimate that the clothing and home business is being valued by the stock market at about £100m, despite the fact M&S is the UK’s number-one clothing retailer by market share and is forecast to make operating profits of over £300m this year,” says Lance. As a result, he believes the clothing and home business should be valued closer to £3bn, which if added on to today’s share price would provide an upside of 80%. “Putting this all together suggests that investors are yet to recognise the true value of the business,” he says. Philosophically, he believes investors have a tendency to overreact to short-term news. As a result the investment process that underlines the TM Redwheel UK Equity Income Fund aims to rotate around the market to where the team identifies areas of undervaluation created by the overreactions. “When the economy goes into a downturn investors become very fearful and tend to sell down cyclical stocks to a much lower level than they probably deserve to be,” he says. Instead, the Redwheel UK Value team describe themselves as long-term intrinsic value investors who use these overreactions by market participants to purchase stocks at less than their true value. “Buying shares at a discount to their intrinsic value is a defensive strategy that builds in a margin of safety, but also offers attractive total return potential through both dividend and capital appreciation,” says Lance. Joining Redwheel from Schroders in 2010, Lance and co-manager Nick Purves have been running value money for more than 30 years. The team also includes portfolio manager John Teahan and two analysts, Jaako Kinanen and Larry Furness, who assist with portfolio implementation and company research. So what are Lance’s 30 years of experience telling him about the current investment climate, in which investors are still clamouring for tech and growth? “Rivian, a 12-year-old electric vehicle manufacturer with no revenue, listed on the US stock market in November last year and the shares doubled to the point that its market cap of $140bn made it the third-most-valuable carmaker in the world – just ahead of Volkswagen ($139bn), and in third place behind Toyota ($306bn) and Tesla ($1trn),” he says. "To put the fact that it was valued more highly than Volkswagen into perspective, it is expected to produce about 1,000 cars this year versus 9.3m Volkswagen produces.” Lance says what the Redwheel Value & Income team is trying to highlight is that there are still some very undervalued stocks available to investors, including those that are so cheap that one division is worth more than the market cap of the entire group. “In some cases they are priced on mid-double-digit free cashflow yields and high single-digit dividend yields,” he says, “But rather than take advantage of these bargains, investors are chasing story stocks like Rivian or ploughing their money into cryptocurrencies and non-fungible tokens. “There are distinct echoes of 2000 in this behaviour and when the music stops, we know where we would rather be invested.”
‘When the economy goes into a downturn investors become very fearful and tend to sell down cyclical stocks to a much lower level than they deserve to be’
Clients need to be aware of potential style drift in their portfolios. Historically, value investing has done well during periods of inflation. UK equities are trading at the greatest discount to world equities for 50 years. UK value stocks are on the greatest discount to growth stocks.
In this video Simon Rogers, head of UK advisory sales & strategic partners at Redwheel, answers some of the most frequent questions he receives from clients
‘Over the next 10 years investors need to be even more aware of valuations, cashflows & pricing power’
head of UK advisory sales & strategic partners at Redwheel
Simon Rogers,
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‘I absolutely still believe value investors have a fantastic opportunity to have a greater impact in terms of ESG and sustainability‘
portfolio manager, Redwheel
John Teahan,
