09.03.2018

M&G International Investments Switzerland AG

Lessons from a decade of value investing

On the tenth anniversary of the launch of the M&G European Strategic Value Fund, Fund Manager Richard Halle reflects on the lessons learned during a tough time for value investors. In his view, a disciplined process is the key to coping with the challenges associated with investing in cheap stocks. Despite a difficult few years, he believes value investors should keep the faith.

A tough time for value
The M&G European Strategic Value Fund was launched in February 2008. As the name suggests, the fund follows a value approach to investing, based on the belief that buying the cheapest stocks in the market delivers superior returns over the long term.

Remember that the value of investments will fluctuate, which will cause fund prices to fall as well as rise, and you may not get back the original amount you invested. Also,
changes in currency exchange rates will affect the value of your investment.

With hindsight, we can see that this proved to be a rather unfortunate moment to start a value investing strategy. At the time, value investing was widely recognised as a
successful long-term strategy. For most of the previous couple of decades, the value style had outperformed. However, since 2008, it has been a rather different story:
value has underperformed for a sustained period.

There are numerous reasons for value’s reversal, in our view. The fund was launched during the global financial crisis (GFC), which was followed by the eurozone debt
crisis. In this environment, risk-averse investors sought the perceived safety of higher quality stocks.

With interest rates at record lows, investors have also favoured so-called ‘bond proxies’ – stable companies offering steady income streams. These characteristics are
not typically associated with value stocks. Investors should bear in mind that past performance is not a guide to future performance.

The past 10 years have certainly been tough for value investors; some are beginning to question whether the value premium still exists. As we reflect on what has arguably
been the most challenging decade ever for the value style, here are some of the lessons we have learned.

Robust process is crucial
The first is that when investing in cheap, out-of-favour stocks, a robust process is important. Being a contrarian investor, by definition, means running against the crowd –
something that’s been demonstrated by the performance of the value style more recently.

We recognise that value investing is a difficult strategy to implement and there will inevitably be times when it goes wrong. As a result, we believe a disciplined and repeatable process is essential to managing the inevitable short-term headwinds. Our differentiated process seeks to mitigate some of the shortfalls that are typically associated with value stocks.

Sector screening
For a start, we seek to avoid having a portfolio concentrated in particular sectors. The cheapest stocks are frequently found in certain areas. We believe it is important to look
deep and wide for value opportunities, to avoid fund performance being dominated by stocks in one or two sectors, which could lead to excess risk and volatility.

To illustrate this point, think back to 2008/9, when financials were among the cheapest stocks in the market. Without applying our sector screen, the fund might have had a large allocation to banks. This would have proved to be extremely painful, given the losses the financial sector suffered in the following years.

A decade on from the GFC and after numerous bailouts, rescues and restructurings, we feel comfortable enough for the fund to be overweight in banks again relative to the
MSCI Europe Index.

Fundamental analysis
Another key element that we believe helps overcome some of the challenges of value investing is our rigorous fundamental analysis. We spend considerable time
assessing the underlying merits of potential investments to try and determine whether they are being mispriced.

We focus on a company’s financial strength, the durability of the business and the behaviour of the management. By looking at these factors, we aim to identify and exclude
structurally challenged firms. We try to avoid stocks with significant problems that will prevent their share prices recovering – the so-called ‘value traps’.

This is not to say we have always been successful. Over the years, we have had our share of disappointments. There is considerable uncertainty involved with cheap stocks, and plenty of stocks have failed to recover. However, we believe that by not compromising on our process, we have avoided many value traps.

Patience is important
Our experience has taught us that the process of mean reversion can be long and drawn-out. At times, we have been too early to recognise mispriced opportunities, and stocks have declined before they have recovered. In our view, value investors need to be relaxed about how long it takes for a company’s share price to re-rate to a valuation that reflects the underlying reality of the business.
We do not believe that there is any great benefit in looking for potential catalysts – the fact that a stock is cheap is enough for us. We have confidence in mean reversion and are prepared to wait three to five years for a stock to recover and for us to maximise the value premium on offer.
Given that value investing is unpredictable and requires a long-term horizon, we believe that it is essential to a build a diversified portfolio. The risks associated with individual value stocks are fairly high. As a result, we do not think it is sensible to have high-conviction positions in individual stocks or a concentrated portfolio. Instead, we believe a well-diversified portfolio of cheap stocks is the best way to capture the value premium and mitigate volatility.

Staying true to value
The final and possibly most significant observation about the past decade is the importance of a consistent process. Despite the considerable headwinds to the value style, we have stayed true to value. We have not modified our process by straying towards momentum or growth when value has struggled.
We have consistently applied a simple, repeatable process that invests only in the cheapest stocks in the market (the cheapest 25% in each sector, typically on a price-to-book basis). This is because, despite the challenging environment, we believe that the value premium exists.

Fund performance
Encouragingly, even though value has been out of favour for most of the time the fund has been in existence – 2016 was a notable exception – the fund has performed well. Since inception, the fund has returned 5.8% pa (Euro A class shares), outperforming not only the MSCI Europe Value Index (+3.8% pa) but also the broader MSCI Europe Index (5.2% pa) and its peer group (+4.3% pa).

Past performance is not a guide to future performance.

We believe this is attributable to our differentiated process. The strict valuation-focused screening has ensured that the fund has consistently had a value bias. Our fundamental analysis has helped us avoid value traps and focus on the stocks that have a high probability of share price recovery.

Keep the faith
We believe the fund is well positioned for the future, having coped with the challenge of value’s sustained underperformance in the past decade. As many investors have realised over the past 10 years, timing the value cycle is extremely difficult. With a consistent value bias, the fund has the potential to perform well when value returns to favour. At the same time, we are optimistic that it could deliver attractive returns even if value continues to underperform. Please bear in mind, however, that past performance is not a guide to future performance.
We believe value investors should keep the faith. Despite a tough time recently, we think the value premium still exists. Today, the valuation spread between the most expensive stocks in the market and the cheapest has rarely been wider. In our view, this situation offers attractive opportunities for patient, value-focused stockpickers.

M&G / March 2018

Please note that the fund invests mainly in company shares and is therefore likely to experience larger price fluctuations than funds that invest in bonds and/or cash.

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