Will 2001 be a good year for value investing? Value investors enter 2001 in an optimistic mood. The ...
Will 2001 be a good year for value investing? Value investors enter 2001 in an optimistic mood. The stock market's long-running pre-occupation with growth stocks, and the new economy in particular, ended dramatically last year. The rally in traditional sectors has gone some way to redressing years of painful underperformance suffered by value investors.
Such optimism is fragile however. Although many growth stocks did become over-rated at their peak, it is still not clear that traditional sectors are safer. Can the old economy reverse a decade of tough competition and slow growth?
With a sharp slowdown in the US economy likely to spill over into the UK and Europe, there are now risks for all investors. But value investors in particular may be at greater risk if they buy traditional cyclical businesses. Identifying value this year will be a subtler business. Areas of low economic sensitivity, such as niche businesses with consistent growth, may be safest at this late stage of the cycle.
Investors must also look beyond superficial measures of value, as there are value traps in apparently cheap companies whose published earnings are misleading. Eight years of sustained growth of the UK economy should be the ideal background for manufacturing and cyclical businesses, yet global competition has combined this growth with a tough pricing environment. The re-rating of cyclicals has lost sight of the implicit risks within these companies. Most operate in intensely competitive global markets, with little or no pricing power. Their lower ratings typically reflect lower earnings visibility and further profit warnings and downgrades are likely for many. Successful value investing involves putting a price on real organic growth and recognising when companies are cheap for a good reason.
Traditional value areas
Nor is dividend yield a strong support in some traditional value areas. Where there are deteriorating profit patterns and low inflation, there can be no long-term guarantee over dividend levels. Dividends can be cut overnight. The first signs of a profits squeeze, which could eventually harm dividends, is already evident in sectors such as utilities and transport. Yield is not value. Marks & Spencer and Corus are just two examples of this misunderstanding of high yield stocks that were private investor favourites until dividends were cut.
Many mistakenly equate a low price/earnings ratio with value. When profits collapse, earnings multiples can rise even as a share price is falling. Some of the most disappointing investments of the last two years have been cyclical businesses on low ratings, whose results have consistently disappointed. Falls in stocks like Invensys and British Telecom, for example, have still left these shares looking more expensive than a year ago. BT illustrates just how important debt is within the overall value equation. A falling share price is not a bargain if offset by rising debt.
Some value investors have been attracted by asset values, which appear to underpin many traditional businesses. But a low return on capital often points to over-stated asset values. Assets are only worth what they can earn. Any buyer of those productive assets will want to make a normal return and pay a price that reflects this reality. There is no guarantee that the apparent asset backing of some businesses is tangible and realisable.
Indeed, if there is excess capacity in areas such as steel or high street retailing, there may be few willing buyers to allow easy downsizing. Assets are often a value trap, enticing value investors who lack realism.
Rate boost to industrials
Over the next twelve months, industrial stocks may benefit from interest rate cuts, a weak pound and lower oil costs, but could find this is still not enough to offset softer demand. The disappearance of inflation has made the last few years a tough time for many traditional value stocks in heavy industries. Inflation can no longer flatter growth in declining businesses. There is now a sharp division between true cash generative growth and cyclical value businesses. Low inflation is exposing weak business strategies and forcing a reappraisal of value investment methods.
Simply buying into steel or other commodities on the basis of help from oil price weakness has great risks. A weak pound should benefit exporters from the UK into Europe, or groups such as ICI, but with weaker industrial demand in the US, there will be more competition for market share.
The best opportunities for value investment this coming year are likely to be in consumer areas. Interest rate cuts and fiscal stimulation in the UK and Europe should be positive for retailers and other consumer-oriented sectors and there are already signs that pressures on the high street have eased. Yet even there, segments such as clothing are still difficult, with companies such as Arcadia and Marks & Spencer struggling with high cost bases. Betting on a major turnaround is risky. There is value to be found in consumer sectors, but investors must be selective. Many share prices in consumer sectors have already rallied sharply, discounting some of this better outlook. Several of what are generally seen as value consumer stocks are now quite expensive.
Share ratings slowdown
Share ratings may not improve much this year as performance will be driven by profits growth. Value investors must focus on whether a company's results show positive earnings surprise, while investors' earnings forecasts must be ahead of the consensus to justify purchase. Examination of the factors behind earning growth will also be essential. Where companies are reporting earnings per share growth ahead of underlying real sales growth, this may reflect cost cutting or improved efficiency. This type of growth may also not be repeatable and hence not worth paying a multiple of earnings for.
Value investors have
Janus Henderson Global Dividend Index
More than 10 million shares allocated
Long-term strategic holding
What made financial headlines over the weekend?
To promote 'long-term investment'