Is there such a thing as irresistible value? In this article, Stephen Payne, lead manager on the Janus Henderson Cautious Managed Fund, picks four key charts and gives his view on the potential value in UK equities at present, in the face of ongoing Brexit uncertainty.
I feel like a child in a sweet shop at the moment; there are so many appealing value opportunities in the UK equity market. The dispersion in valuations across the market has stretched to extraordinary levels. Value stocks are the cheapest they have been compared to growth stocks for many years, as chart 1 shows:
Chart 1: The price dispersion between growth and value continues to stretch
Source: Barclays Research, Thomson Reuters DataStream, MSCI UK Growth Index 12-month forward price/earnings (P/E) ratio divided by MSCI UK Value Index 12-month forward price/earnings ratio, 31 January 2006 to 31 May 2019. Standard deviation here expresses how much the performance of growth versus value differs from its average performance over the long term. For a normal data set, about 68% of the values in a group fall within close proximity to the average (+1 or -1 standard deviation). Anything outside this is considered a ‘significant’ outlier by historic standards.
The price-to-earnings (P/E) ratio is a popular ratio used to value a company’s shares. It is calculated by dividing the current share price by its earnings per share. In general, a high P/E ratio indicates that investors expect strong earnings growth in the future (with exceptions). A relatively low P/E ratio may indicate that a company is undervalued, given its assets and prospective revenues, although it may also be indicative of a company in difficulty (ie. not all cheap stocks are good value). P/E is not an absolute measure of value; rather it can be used as a helpful indicator of value relative to the market, as part of a more detailed analysis.
The number of stocks now trading on single-digit price/earnings (P/E) ratios in the UK has ballooned in the last two years. In 2015 there were only eight such value opportunities; as at the end of May 2019, there were 67 (chart 2).
Chart 2: Are UK stocks being priced on crisis lows?
Source: FTSE 350, Janus Henderson Investors, price/earnings (P/E) ratio, as at 30 May 2019. P/E is not an absolute measure of value; rather it can be used as a helpful indicator of value relative to the market, as part of a more detailed analysis.
It has undoubtedly been a challenging period for value investors. The ‘value’ style of investing has lagged ‘growth’ for more than a decade now, in part due to the impact of central banks’ unprecedented stimulative measures (such as quantitative easing). But no market trend goes on forever. Some of us are old enough to remember the 1980s, 90s and early noughties, a sustained period where value consistently outperformed growth (see chart 3):
Chart 3: Value outperformed growth for more than two decades
Source: Thomson Reuters DataStream, 1 January 1975 to 3 June 2019. MSCI UK: Value Index divided by MSCI UK: Growth Index, relative performance expressed as a percentage. Rebased to 100 at start date. A rising line indicates value outperforming growth; a decline indicates the outperformance of growth.
The question that exasperated value investors frequently ask is what it might take to challenge the outperformance of growth at the expense of value. As a value-conscious investor I have sympathy for this viewpoint, but in my experience a catalyst often only becomes obvious after the event, once share prices have already moved. However, we are able to consider factors that we believe may be relevant. There is a clear correlation, for example, between the relative underperformance of value and falling bond yields. Given how low bond yields are now (the yield on German 10-year bunds is negative, while 10-year Gilts are yielding just 0.85% as at 14 June 2019) the likely direction must be biased to the upside, which would be a boon for value investors.
Chart 4: The Value/Growth trade is based on the direction of bonds yields
Source: Thomson Reuters DataStream, 1 January 2018 to 16 June 2019. Performance of the MSCI UK Value Index versus the MSCI UK Growth Index. UK Government Benchmark Bid Yield 10 Years (sterling).
Is there currently unprecedented relative value in UK equities?
The past two years have seen us add exposure to growth stocks to the portfolio, dialling down our exposure to what we saw as stocks with somewhat better long term value. This was, in our view, a sensible decision, given ongoing uncertainty about the direction of the UK economy and the persistent uncertainty surrounding Brexit.
Recent weeks, however, have seen us adding more to value names, increasing this component of our equity portfolio. We now hold 17 stocks that have single-digit prospective P/Es and 26 holdings that yield more than 5%, with the overall equity portfolio offering a prospective yield of 4.8%. We remain firm believers that the price you pay is the key determinant of your long-term returns. On that basis, we believe the UK represents an intrinsic opportunity for long-term performance, although it may take time for this investment rationale to come through. UK investors are also being paid well for their conviction, with the average dividend yield of 4.3% on the FTSE All-Share Index - more than 0.5% higher than the long-term average for the market (dating back to 1924).
Investing in value is undoubtedly contrarian at the moment, but all the best trades are. Take tobacco firm Imperial Brands. The stock is unloved at the moment and has steadily lost ground since its year-to-date peak in February. Almost by definition, a value stock will have some concerns around its prospects. In the case of Imperial Brands, investors are worried about regulatory issues in the US and the disruption from next-generation products such as vaping. In our view, these are more than reflected in the valuation of the stock, which trades on a relatively low price/earnings ratio of 7.4x earnings – a level that does not, in our view, reflect its value or prospects. The stock also offers a dividend yield of 10%, reflecting the large amount of cash generated by the business. We expect these very strong and robust cash flows to ultimately determine the value of the shares, even if short-term sentiment and noise around the stock is negative.
These are the views of the author at the time of publication and may differ from the views of other individuals/teams at Janus Henderson Investors. Any securities, funds, sectors and indices mentioned within this article do not constitute or form part of any offer or solicitation to buy or sell them. Past performance is not a guide to future performance. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested. The information in this article does not qualify as an investment recommendation. For promotional purposes.
(Price) dispersion: The variation in prices across the market for similar companies, or those producing similar products, or operating in the same area of the market.
Growth investing: Growth investors search for companies they believe have strong growth potential. Their earnings are expected to grow at an above-average rate compared to the rest of the market, and therefore there is an expectation that their share prices will increase in value.
Value investing: Value investors search for companies that they believe are undervalued by the market, and therefore expect their share price to increase. One of the favoured techniques is to buy companies with low price to earnings (P/E) ratios.
Quantitative easing: An unconventional monetary policy used by central banks to stimulate the economy by boosting the amount of overall money in the banking system.
Yield: The level of income on a security, typically expressed as a percentage rate. For equities, a common measure is the dividend yield, which divides recent dividend payments for each share by the share price. For a bond, this is calculated as the annual coupon (interest) payment divided by the current bond price.
Dividend yield: The income received on an investment relative to its price, expressed as a percentage. It enables comparisons of the level of income provided by different investments (or asset classes) such as equities, bonds, cash or property, or between funds at a point in time.
Gilts: British government bonds sold by the Bank of England, issued to finance the British national debt.