Why value investing is making a comeback

In recent years, investors have been prepared to pay a large premium for the perceived safety of stable dividends and growth rather than hunt for potential bargains.

Since the global financial crisis, value stocks have been consistently overlooked by investors. Instead they have been happy to pay relatively high prices for what they perceive to be safer, quality stocks.

Moreover, in the low-to-no interest rate environment and without a competitive alternative from bonds, investors flocked to these 'bond proxies' for their low volatility and steady yield.

The market data tells the same story. Given the current economic and political backdrop, the UK market is highly priced relative to history. Within the FTSE All-Share Index, valuations for companies as a multiple of prospective earnings are trading close to 10-year highs.

But if not supported by sustained earnings growth what is the reason for the high prices? Much of the uplift in company valuations in the UK over the last 12 months has been down to market re-rating - helped in part by currency tailwinds, and then dividend pay-out.

Value over growth investing

However, the tide is turning, and we have recently seen the beginning of a rotation into value. These stocks, which trade at a discount to the assets or cashflows they represent, can be found more easily in the smaller company range, typically under £100 million in size. They have healthy cash flows and offer scope to generate superior returns over the long-term.

Many investors who have put all their eggs in the growth stock basket over the past decade are waking up to the fact that contrarian investing can generate significant returns. Drawn by the prospect of healthy cash flows, superior long term investment returns, and responding to rising inflation expectations and bond yields, they are turning their attention to value stocks.

But is the rotation to value that we saw in the second half of 2016 simply a one off? Or is this the beginning of a trend that is going to endure in the long term? I believe value's comeback is just getting started. I expect continued momentum in the coming years with expectations of rising interest rates alongside inflation. Meanwhile investors are becoming increasingly nervous of very high valuations against a backdrop of lower growth expectations and ongoing geo-political uncertainty.

Historically value has outperformed growth

Value is shown to outperform growth over the long-term and historically, when we have seen value begin to come back into favour, the recovery has been strong.

Rather than focusing on companies operating at peak margins and at the upper end of historic valuation ranges, investors should focus on good quality, lowly valued companies, where opportunities for increasing shareholder returns are identified from a combination of: earnings growth, increased market profile, excess cash generation and where return on capital and balance sheet efficiency can be improved.

Buying in at attractive prices below intrinsic value and holding over the long term is one of the best ways for an investor to ensure above average returns. There is significant opportunity at the smaller - sub £100 million - end of the market where there are greater inefficiencies and where you typically see a dislocation in valuations versus their intrinsic value of underlying assets.

However, investors need to be wary of falling into the 'value trap', even if a stock exhibits all the characteristics listed above there is no guarantee that it's a true value investment. Identifying true value stocks requires in-depth analysis, which is sometimes difficult as they are often under researched.

Therefore, investors are increasingly gaining exposure investing through a fund or investment trust that has the appropriate research capabilities and an experienced manager on board who can work with management teams to support clear value creation plans over the long term. Many of these principles are exhibited in a private equity style investment approach.

This article was originally published in our sister magazine Money Observer. Click here to subscribe.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.