Contrarian strategies can pay off
Value-based investing has a keen following, thanks to its links with such illustrious investors as Warren Buffett, Sir John Templeton and Anthony Bolton. It is especially popular in the US, where numerous studies have demonstrated its long-term success.
In the UK too, it has enjoyed extensive periods in the sun interspersed with setbacks, such as the dotcom boom in the late 1990s and the latter stages of the 2003-08 bull market.
Some, but not all, of its adherents lagged in last year's recovery. However, it would not be a surprise to see the laggards make up lost ground in 2010.
With this in mind, Money Observer has analysed which investment trusts have combined a value approach with superior long-term returns, with a particular focus on the UK growth & income sector, where most of the constituents have a strong value orientation.
Having considered which of the UK growth & income trusts have served investors best, we have compared their returns with the champion long-term dividend growers of the wider investment company universe, many of which have comparatively modest yields.
What is value investing?
Value investing, as a concept, is difficult to pin down. First promulgated by Ben Graham and David Dodd in 1928 at Columbia Business School, it involves buying shares that are significantly underpriced relative to their intrinsic value and waiting for the market to wake up to their true worth.
However, while the establishment of that intrinsic value almost invariably involves in-depth company research, the parameters by which value is judged vary widely.
In many cases they include a wide discount to net asset value (NAV) and/or a low price/ earnings or price to free cash flow ratio.
The latter measure is seen as less open to manipulation. Some value investors look for a strong balance sheet. Others also seek a high dividend yield on the basis that this ought to be a characteristic of a well-managed but undervalued company.
All adherents emphasise that returns can take years to come through and investors must not lose faith during disappointing periods.
Who has made it work?
As head of Aberdeen Asset Management's Far East team, Hugh Young led the development of the value-based approach that has served it well in that region for close to 20 years.
Despite periodic dull patches, Aberdeen Asian Smaller Companies and Aberdeen New Dawn are placed second and fourth in the Asia Pacific excluding Japan sector in terms of 10-year total NAV returns.
The first and third places go to Scottish Oriental Smaller Companies and Henderson Far East Income trust, which are also value-oriented. In contrast, Henderson's growth-oriented contender, Henderson TR Pacific, is way down the list.
Aberdeen's other contender, Edinburgh Dragon, came seventh out of 12, but it adopted the value approach in 2003.
Young's approach has worked less well for some of Aberdeen's non-Asian trusts, which were expected to adopt the strategy after he became head of equities across the group in 2002.
However, Murray Income Trust has been working its way up the 10-year tables and Murray International Trust has gone from strength to strength.
Bruce Stout, Murray International's manager, is wary of a value label, but admits he manages the trust totally on a bottom-up, company-specific basis.
He seeks to identify growing companies and is prepared to wait years to buy them cheaply. "Never pay up for anything, even if it is the best quality asset in the world," he says.
Templeton Emerging Markets Investment Trust's value orientation has also served it well in far-flung markets, with 10-year total NAV returns usefully ahead of the demanding MSCI All World Emerging Markets index, and well ahead of its rivals.
Manager Mark Mobius's selections are guided by two core tenets: buy at a discount to projected future earnings, cash flow and asset value potential, and hold until the market recognises that worth. "We look to find good bargains on a five-year view," Mobius says.
Top 10 performers
Emerging markets have been greatly favoured by some trusts in the global growth sector, but not particularly by the top performers over 10 years, namely British Empire Securities and General Trust (BES&G), RIT Capital Partners, Law Debenture, Gartmore Global and Personal Assets.
BES&G is firmly in the value camp, as is the investment manager of Law Debenture, James Henderson of Henderson Global Investors.
His colleague Alex Crooke has achieved above-average 10-year returns for Bankers Investment Trust with a value-oriented style, while the newer EP Global Opportunities Trust, run by Sandy Nairn, chief executive officer at Edinburgh Partners, has made a value approach work well over the past five years.
Robert Siddles has managed F&C US Smaller Companies since 2001, and is the most value-oriented of the US investment trust managers. His trust has done twice as well as the Russell 2000 index over the past 10 years.
Closer to home, the top two UK growth trusts of the decade have both had a value bias. Fidelity Special Values was managed until the end of 2007 by Anthony Bolton. His value and contrarian orientation has been broadly maintained by his successor Sanjeev Shah.
"I like companies that are unloved, overlooked or misunderstood," Shah says. "I am prepared to go in fairly early, even if I can't spot the catalyst for change.
"But I don't want to fall into the value trap of backing companies that will never recover. I look for inherent value that can be unlocked over time."
Meanwhile, Capital Gearing Trust's manager Peter Spiller has achieved much of his outstanding long-term success through buying investment trust shares at a discount, which he expects to diminish.
On the smaller companies front, Aberforth UK Smaller Companies Trust has the most firmly value-oriented style and the best 10-year returns of the mainstream UK trusts, but owes most of its outperformance to the 2000-03 bear market, when it benefited from the very defensive companies in its portfolio.
Montanaro UK Smaller Companies Investment Trust has a well above average 10-year record, and claims to follow a Warren Buffett style by investing at a significant discount to the net present value of the future free cash flow of its holdings.
However, Montanaro director Stephen Cohen says: "It is only value with a small 'v', as we don't mind paying up for a business that is really high quality."
Winners in UK growth and income
Many of the trusts already cited have modest yields, not least because they focus on areas that have historically been short on dividends.
However, many have worked hard to achieve a progressive dividend policy. BES&G, for example, has raised its dividend every year since 1985.
Growing awareness of the need to serve shareholders well in Europe and Asia is opening the way for more overseas income vehicles, which tend to be more value oriented than their growth counterparts.
But the main source of equity income remains the UK because that is where dividends have historically been highest.
The investment trusts in the UK growth & income sector target an attractive and rising dividend. This is a critical attraction to investors who depend on their investments for their spending money, given that the interest rate on bonds is fixed and inflation is edging up.
Buying at an above-average yield, combined with good prospects for dividend increases, ties in naturally with a value approach.
Maintaining a rising payout has become more difficult for investment companies following last year's widespread dividend cuts. Currency fluctuations are also muddying the waters.
However, unlike open-ended funds, closed-end investment trusts can put up to 15% of their income into revenue reserves during the good years (offshore investment companies can retain a higher amount).
This helps trusts keep payouts edging up through harder times, although some have not achieved this.
While trusts in the sector have broadly similar remits, some have inevitably been more successful that others, and it is instructive that none of the top three performers over 10 years has strained to be among the top yielders.
Mark Barnett, manager of Perpetual Income & Growth, emphasises that he aims for a growing rather than a high dividend. This allows him a much wider choice of investee companies than managers with a higher immediate yield requirement.
That has made it easier to achieve above-average growth in the assets on which future dividend growth will depend.
In other words, he has given up a bit of dividend today in return for improved dividend prospects in the future, and those who need to cash in will have a much better capital return.
Temple Bar also has a comparatively modest yield. Manager Alastair Mundy says he takes a contrarian approach to investing, which he describes as "subtly different" to a value strategy.
"As contrarian investors, we are only interested in companies that have significantly underperformed because they have fallen from favour, whereas value investors are drawn to companies that are cheap," he says.
Lowland Investment Company comes third, having bounced back strongly from a disastrous 2008, when manager James Henderson was far too early to buy back into financial and construction shares.
This was a startling loss of form by one of the most seasoned value investors, and is a reminder that no one is infallible. Unlike its peers, Lowland charges all its costs and expenses to the income account, which enhances its capital growth performance but pulls down its yield.
It did not increase its dividend last year despite having revenue reserves equal to a year's payout.
The higher-yielding trusts are mostly in the lower half of the sector in terms of 10-year total return, and in several cases the NAV per share has fallen over the decade.
The implication is that their supporters have enjoyed strong dividend returns at the expense of capital appreciation, and this will make it increasingly difficult to increase dividends in future.
Worst of all has been Edinburgh Investment Trust. It has recently made up for lost time on the dividend front, but capital growth has disappointed.
The trust moved its management mandate to Invesco Perpetual in 2008 in the hope that star manager Neil Woodford could turn its performance around.
Woodford positioned the trust defensively and did not make the most of last year's rally.
However, as a value-oriented investor, he suffered similarly poor periods in the late 1990s and at the turn of the market in 2003. But those investors who kept their faith were eventually well rewarded.
Marathon dividend growers
As Woodford suggests, the search for dividend growth can conflict with capital growth. Fourteen investment trusts, between 26 and 43 consecutive years, have raised their dividends every year.
However, some have achieved greater dividend growth than others and some have struggled to combine this with capital gains.
The more value-oriented of the long-term dividend growers are all in the top half of the table, which lends support to the contention that value investing works well over time.
The past decade was tricky for many investors, but the statistics show that the UK growth & income sector was one of the duller performers over that period, lagging global growth, global growth & income, UK growth, Europe, Asia Pacific ex Japan and global emerging markets.
A lot of returns from investing may come from income, but squeezing more income from trust assets can become progressively difficult if the initial level is overly demanding.
"Be a tracker if you can't stand the heat"
Neil Woodford says his overriding criteria for picking a company is not its quality, but whether it is overvalued or undervalued. "I look for long-term value situations. My average holding period is five or six years and I am prepared to ride out markets I don't agree with.
"Anyone who follows that style has to accept that from time to time they will fall behind. If they can't stand the heat they should give up and become an index tracker.
"I am a valuation-driven long-term investor, not a high-income manager. You must never let the distribution of companies dictate what you own and I do not let income targets rule my portfolio strategy. Total returns must be the overriding objective.
"If I felt I had to stray away from high-yielding shares (to safeguard the total return on Edinburgh Investment Trust), I would have to discuss it with the board."
Hunting in Europe
Since John Pennink took charge in 2002, BES&G has outperformed the MSCI World index in every year bar 2008.
He looks for closed-end funds and holding companies with good quality assets that are selling at substantial discounts to NAV, and finds Europe a particularly happy hunting ground.
"Continental European holding companies are conservatively run, have strong balance sheets and are not too hard to understand, and there can be lots of scope to add value by buying at wide discounts and selling at narrower ones," he says.
Pennick has little in the US because it is so well picked over by other value investors.
Honesty and clarity are key
Describing Aberdeen Asset Management's approach, Hugh Young says: "We try to identify long-term winners, run by honest people, and buy as cheaply as possible.
We do a lot of homework to make sure companies have a decent business with decent finances, and avoid anything we do not fully understand or which is not being run primarily in the interests of its shareholders.
"Every company is visited at least once before it is purchased and regularly thereafter. The emphasis is on long-term value, rather than short-term opportunity, so annual portfolio turnover is expected to be 20% or less.
"The strategy is simple: buy and hold, add on the dips and take profits on price run-ups. Typically, we do relatively badly in times of greed when people throw fundamentals out the window. But in times of fear our funds come through once again."
This article was originally published in Money Observer - Moneywise's sister publication - in April 2010
Net asset value
A company’s net asset value (NAV) is the total value of its assets minus the total value of its liabilities. NAV is most closely associated with investment trusts and is useful for valuing shares in investment trust companies where the value of the company comes from the assets it holds rather than the profit stream generated by the business. Frequently, the NAV is divided by the number of shares in issue to give the net asset value per share.
Investment trusts are companies that invest money in other companies and whose shares are listed on the London Stock Exchange. As with unit trusts, private investors buying shares in an investment trust are buying into a diversified portfolio of assets (to reduce risk), which is managed by a professional fund manager. Investment trusts differ from unit trusts in two important ways: they are listed on the stockmarket and so are owned by their shareholders and are closed-ended funds with a finite number of shares in issue. This means the share price of investment trusts might not reflect the true value of the assets in the company (known as the net asset value, or NAV) and if the NAV value of a share is £1 and the share price in the market is 90p, the trust is said to be running a discount of 10% to NAV. But this means the investor is paying 90p to gain exposure to £1 of assets. Investment trusts can also borrow money and use this money to buy investments. This is known as gearing and a geared trust is thought to be more of an investment risk than an ungeared one.
The practice of locating your financial affairs (banking, savings, investments) in a country other than the one you’re a citizen of, usually a low-tax jurisdiction. The appeal of offshore is it offers the potential for tax efficiency, the convenience of easy international access and a safe haven for your money. However, offshore is governed by complex, ever-changing rules (such as 2005’s European Union Savings Directive) and, as such, is the exclusive province of the wealthy and high-net-worth individuals.
A catch-all phrase that can range from assessing the price of a property or vehicle before offering it for sale or the net worth of assets in an investment portfolio to the prices of shares on a stock exchange.
The general term for the rate of income from an investment expressed as an annual percentage and based on its current market value. For example, if a corporate bond or gilt originally sold at £100 par value with a coupon of 10% is bought for £100 then the coupon and the yield are the same at 10%, or £10. But if an investor buys the bond for £125, its coupon is still 10% (or £10) and the investor receives £10 but as the investor bought the bond for £125 (not £100) the yield on the investment is 8%.
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).
Investors who borrow money they use for investment and use the securities they buy as collateral for the loan are said to be “gearing up” the portfolio (in the US, gearing is referred to as “leveraging”) and widely used by investment trusts. The greater the gearing as a proportion of the overall portfolio, the greater the potential for profit or loss. If markets rise in value, the investor can pay back the loan and retain the profit but if markets fall, the investor may not be able to cover the borrowing and interest costs, and will make a loss. Also used to describe the ratio of a company’s borrowing in relation to its market capitalisation and the gearing ratio measures the extent to which a company is funded by debt. A company with high gearing is more vulnerable to downturns in the business cycle because the company must continue to service its debt regardless of how bad sales are.
A bull market describes a market where the prevailing trend is upward moving or “bullish”. This is a prolonged period in which investment prices rise faster than their historical average. Bull markets are characterised by optimism, investor confidence and expectations that strong results will continue. Bull markets can happen as a result of an economic recovery, an economic boom, or investor irrationality. It is the opposite of a bear market.
If you own shares in a company, you’re entitled to a slice of the profits and these are paid as dividends on top of any capital growth in the shares’ value. The amount of the dividend is down to the board of directors (who can decide not to pay a dividend and reinvest any profits in the company) and they will be paid twice yearly (announced at the AGM and six months later as an interim). Dividends are always declared as a sum of money rather than a percentage of the share’s price. Although dividends automatically receive a 10% tax credit from HM Revenue & Customs (HMRC), which takes the company having already paid corporation tax on its profits into account. Dividends are classed as income and, as such, are liable for personal taxation and so shareholders have to declare them to HMRC.
Generic, loosely-defined term for markets in a newly industrialised or Third World country that is in the process of moving from a closed economy to an open market economy while building accountability within the system. The World Bank recognises 28 countries as emerging markets, including Argentina, Brazil, China, Czech Republic, Egypt, India, Israel, Morocco, Russia and Venezuela. Because these countries carry additional political, economic and currency risks, investors in emerging markets should accept volatile returns. There is potential to make large profit at the risk of large losses.
An interchangeable term for shares (UK) or stocks (US). Holders of equity shares in a company are entitled to the earnings and assets of a company after all the prior charges and demands on the company’s capital (chiefly its debts and liabilities) have been settled. To have equity in any asset is to own a piece of it, so holders of shares in a company effectively own a piece proportionate to the number of shares they hold. (See also Shares).
This refers to a market situation in which the prices of securities are falling and widespread pessimism causes the negative sentiment to be self-perpetuating. As investors anticipate losses in a bear market and selling continues, pessimism grows. A bear market should not be confused with a correction, which is a short-term trend of less than two months. A bear market is the opposite of a bull market.