The value in value investing

The company, which has a January year end, reported earnings per share in the year ended January 2008 of £1.70, which were up 16% on the previous year. Hence at the lows, investors were valuing the business on less than 5x their reported earnings.

Now, one needs to recall that this was the midst of the Great Financial Crisis; Northern Rock had failed in September 2007 and Bear Stearns was bought out by JP Morgan in March 2008 but the indiscriminate sell off of Next (which was amongst many at the time) still looks like an irrational response. With the benefit of hindsight, it is obvious that this represented a golden opportunity for those willing to extend their timeframes and take the opposite side of this trade as the share price soared to £80 in 2015, a near ten-bagger in seven years (and we were buying shares in Next for our funds throughout 2008)

More recently, similar over reactions occurred at the start of the pandemic with the share price of NatWest Group (formerly Royal Bank of Scotland) trading at the same level in summer of 2020 that it was in 2008 when it had to be rescued by the UK government despite being a much stronger business. The share price of Royal Mail Group troughed at £1.30 in March 2020, only two times the 62p of earnings per share that the company reported in the year ended March 2021. Believers in the efficient market hypothesis would not believe that these sorts of mispricings would be possible given that thousands of investors have access to more real time information than they can possibly use and yet they occur repeatedly.

So why is this?

What links most of these mis-pricings are periods of market stress frequently brought about by a real or anticipated economic downturn.

During these periods of stress, investors’ decision making becomes dominated by the emotional side of the brain rather than the rational side, and the fight or flight instinct means that investors’ time frames shorten.

Rather than calmly consider how much a business is worth on a five-year time frame, investors extrapolate recent earnings and share price declines to the next three to six months and can only see how much damage will occur to their wealth (or for professional fund managers, their employment prospects) if they don’t act quickly.

The result is that they often want to get rid of the stocks which have negatively impacted short term returns in the mistaken belief that this will make the problem go away. For investors who can remain calm, extend their time frames, and appraise the long run value of the business, these situations frequently present opportunities to purchase businesses at significant discounts to their intrinsic value (as the examples above illustrate).

The chart below shows that this pattern has occurred repeatedly over the last twenty-five years and highlights the geopolitical events that caused them.

The line in the chart is the spread in valuation between the most defensive and the most cyclical companies in the UK index and shows very clearly that during the economic downturns highlighted, there is a flight out of cyclicals and into the most defensive companies which depresses the valuation of the former and elevates the valuations of the latter. As the period of stress subsides, so this valuation spread narrows which means that returns from the lowly valued cyclical stocks exceed those of the highly valued defensive stocks.

UK cyclicals vs defensives average valuation premium

Cyclicals versus defensives

Morgan Stanley, 28 April 2022

So, against a backdrop of rising inflation, energy prices and the war in Ukraine, where are ‘new’ opportunities emerging for UK equity investors?

The chart highlights how these factors have led to a similar dispersion in valuations between cyclical and defensive stocks as that which existed at the start of the pandemic suggesting that it is the most cyclical stocks which offer the greatest opportunity today. Many investors will struggle with the idea that anyone would want to own any cyclical stocks at the moment given the widespread expectation that the UK or even the world might soon experience an economic recession. Logic would dictate that if there were to be a recession, you should own defensive stocks until it passes and then buy cyclical stocks during the recovery – but there are flaws in this rationale.

If you know there is a recession coming, probably most other investors also do and hence there is every chance it is priced in. This is certainly what we observe today with defensive stocks looking very expensive whilst cyclicals look very cheap.

To illustrate this, defensive stocks such as Diageo are valued at nearly seven times their annual revenues whilst more cyclical businesses such as ITV, Marks and Spencer, Currys, and Royal Mail trade at between five and seven times their historic earnings and in some cases at significant discounts to their breakup values. Secondly, as the stock market is forward looking, cyclical stocks will typically start to move before the trough of the economic cycle hence investors hoping to benefit from this need to position themselves before economists claim the recession has ended.

Ultimately, your approach to buying shares today will depend on what type of investor you are.

In the last decade, buying businesses at a big discount to their intrinsic value, so-called value investing, has gone out of favour and been replaced by a fashion for trying to guess which businesses will show greatest short-term earnings momentum. Since it is possible that many of these cyclical businesses will be impacted by an economic downturn, the momentum investor is not going to be interested in them yet (in fact some of them are favourite short positions for hedge funds). For the long-term investor, however, history suggests that you are being offered a chance to buy businesses at a fraction of their real value and that as the period of stress subsides, this discount will close and reward the patient investor.

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