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