The Daily Telegraph - Saturday - Money
‘Value’ stocks back in vogue as inflation looms
After years of putting their money into reliable dividend payers, investors are changing tack. Laura Suter explains
The stable companies that investors have ploughed money into in recent years will suffer share price falls while investors in cheap, neglected businesses will prosper as inflation and higher interest rates return. This, at least, is the expectation that has taken hold in the markets following Donald Trump’s US Presidential victory.
The forgotten shares expected to enjoy a strong run are often called “value” stocks. But what is a value stock? They are often described as “diamonds in the rough”: shares that are priced cheaply because of problems either in a particular sector or specific to the company concerned.
These businesses tend to have less predictable earnings and to be more exposed to what is happening in the economy than more “defensive” companies whose earnings are more reliable and less dependent on how the economy is performing.
At the moment, companies in the energy, infrastructure, construction, mining and industrial sectors are considered value investments. However, financial groups, particularly banks, are perhaps the best current example of a value investment (see box, right). Banks’ share prices were hit hard in the financial crisis and again by mis-selling scandals such as PPI. Most recently, the sector has suffered because of the low Bank Rate, which affects banks’ profit margins.
However, since Mr Trump’s win, higher rates and better growth look more likely. The expectation is that he will spend heavily on infrastructure and cut down on immigration, pushing wages up. Higher inflation is the likely consequence, leading to higher interest rates. It is not just an American story: Theresa May recently said Britain’s era of low returns for savers should come to an end.
However, “value” companies have had a hard time. Defensive stocks have outperformed for the past nine years, while value stocks have been lacklustre.
But now there are signs of a major upheaval in the market. A poll of advisers, fund managers and private investors by FE, the data company, found that two-thirds expected “value” stocks to outperform “growth” companies in 2017.
Indeed, for the past few months value companies have outperformed quality growth companies. And there is a long-term trend of outperformance. In America, value companies have outperformed growth companies in seven out of 10 years since 1927. So far this year the iShares S&P 500 Value ETF, an index tracker fund that reflects the performance of US “value” companies, has returned 6.2pc, compared with 2.5pc for the iShares S&P 500 Growth ETF, which follows quality defensive companies. Should investors be changing their portfolios to take advantage of this nascent shift? Darius McDermott of Chelsea Financial Services, the fund shop, said that during times of political uncertainty it was understandable that investors sought safety in steady, defensive companies. “However, by the time we see more than one sign that there is a rotation under way it will probably be too late, so I’d suggest that now is as good a time as any to dip the investing toe back in the value waters,” he said.
Shifts in central bank policy also imply that value shares are about to shine, according to Joshua Ausden of Neptune Investment Management.
“For value stocks to start performing, rates must stop falling,” he said. “This is clearly what we have seen since the beginning of the summer. There has been a definite change in attitude from policymakers in recent months.”
Two funds singled out by FE to benefit from the trend are Invesco Perpetual UK Focus and JO Hambro Capital Management UK Dynamic, although the firm cautioned that investors would need to invest for at least three years to see the theme deliver decent returns.
Mr McDermott said Schroder Recovery, run by Nick Kirrage and Kevin Murphy, was one fund likely to benefit from the trend.
Mr Kirrage said: “Ultimately, value investing is about exploiting human nature, identifying companies where emotions have divorced share prices from long-term reality. This is a constant feature of the stock market over many decades.”
Among the stocks that value fund managers expect to outperform are financial companies such as HSBC, Lloyds and Aviva, oil giants BP and Shell, drugs maker GlaxoSmithKline and telecoms firm Vodafone.
The flip side of this is the defensive companies that investors have piled into for the past few years seem poised to fall. These stable stocks have become known as “bond proxies” because of their tendency to pay a steady yield. Examples include firms such as Unilever, utilities and telecoms companies.
Charles Younes of FE said: “The outperformance of these sectors has led to higher prices which, in turn, has led to overvaluation.” Ben Leyland of the JOHCM Global Opportunities fund said these stocks now reflected dangers in the actual bond market. “They are so expensive they have lost their ‘safe’ characteristics,” he said.
Lloyds is regularly the most traded stock in the UK market – British investors are obsessed. This is despite the share price having plummeted from around 650p in 1999 at its peak down to around 380p ahead of the financial crisis. It now hovers around 60p.
The stock was hit by the EU referendum, falling by around a third. But Donald Trump’s election as US President has caused it to rebound, rising by 8pc amid expectations of higher growth and interest rates.
As one Lloyds insider said, the many staff at the banking group who are investors would be whooping in the corridors if the price went above £1 again, showing how its fortunes have changed since the 2000s.
Adrian Lowcock of Architas, an investment arm of Axa, said that as expectations for the British economy had peaked and fallen, so too had Lloyds’ share price.
The bank’s low current share price coupled with its volatility means it is easy for investors to make decent percentage returns of around 10pc to 20pc, said Mr Lowcock.
However, if Britain returns to higher inflation, higher interest rates and growth, Lloyds is the “pure UK market play” on the trend.
“If interest rates come back and you’ve got inflation, fiscal stimulus and economic growth, Lloyds is probably best placed to benefit from that,” he said.
Banks generally will benefit in such a rising rate environment, but Lloyds is exposed only to the UK market and is a “very straightforward, utility-like bank”, said Mr Lowcock.
The dividend has also made Lloyds a very attractive stock to investors on the hunt for income. The shares currently yield 3.8pc.