The path less travelled: A value approach

Value investing is a simple idea with a long pedigree. Buy companies that trade at a price below their fair value. Determine fair value conservatively, often with a regard for history, and use a margin of safety in case the future proves a little unpredictable, as is invariably the case! Investing like this tends to lead you towards the lower-priced stocks in the market, and historically this has been a good place to be.

Like all good ideas that have been around a while, value investing has its bad patches and dry spells. The philosophy has taken a beating over the last decade, evident both in the returns of quantitative value investment vehicles, and in the perennial market commentary on the ‘death’ of value investing.

The recent numbers speak for themselves, but do not tell the whole story. Since 2010 an investment in the MSCI World Value Index has underperformed its Growth counterpart by a wide margin, with a total return of just 180% over 12 years for the Value index relative to a 345% gain for Growth².

Weak economic growth has led to poor returns from “classic value” sectors like energy, commodities and financials. Low or negative interest rates have reduced borrowing costs, allowing companies to finance rapid expansion with cheap debt and equity rather than profit. These same low yields have pushed investors into ever more speculative assets with longer-dated cash flows.

As a result, average valuations have soared. In 2010, the average price to earnings (P/E) ratio for the S&P 500 Index was 13x. As of December 31, 2021 – before recent pullbacks – it was more than 21x³. Put another way, the price of a single dollar of earnings in the US market has appreciated by more than 65% over this period. Expensive stocks have got more expensive over that long decade, outperforming, and cheaper shares have tended to languish.

This was not always the case. Until 2010, value investing was a reliable way to boost your chances of beating the market. US academics Eugene Fama & Kenneth French maintain market performance datasets stretching back many decades. The numbers show that even just by taking a purely mechanical approach and buying the cheapest 30% of the index each year, this strategy would have delivered an average outperformance of 3.1% per year over more than half a century of data⁴.

Over the last 10 years to the end of 2021 however, low valuation stocks have underperformed high valuation by around 4% per year. While this data is specific to the US, where historic market data is most available, the same is broadly true across other markets.

Recent investors in the UK, or at least those who have invested in purely passive vehicles, thus have cause to feel doubly aggrieved. The UK’s FTSE All Share skews heavily towards classic value sectors when compared with other regional indices like the S&P, Japan’s Topix or Europe’s Stoxx 600.

Furthermore, since the 2016 Brexit vote, asset allocators have not been short of reasons to withhold and/or reduce their holdings, further suppressing valuations. Uncertainty over the country’s relationship with Europe was further compounded by the possibility of a hard left-wing government, whose abatement was then followed by a poor initial handling of the Covid-19 pandemic.

As covered in our previous piece here, these headwinds may slowly be shifting. The UK is emerging from the pandemic with relatively robust economic growth, greater clarity over its trading relationships and the conditions for classic value stocks have rarely been better. These tailwinds could meaningfully boost the performance of UK value stocks across the board.

However, living purely by the ups and downs of any given style is an unsustainable way of running portfolios for the long term. This is why in AllianzGI’s UK Equities team we follow an investment philosophy which is “value driven”. Rather than holding stocks purely on the basis of how cheap they are, we incorporate detailed analysis of fundamentals, as well as an understanding of the longer-term themes which will drive share prices. This is what separates our bottom-up approach to stock picking from a quantitative approach that would simply buy the cheaper stocks in the market. This nuanced approach to value investing has enabled us to deliver top decile market-beating returns across two strategies over 1, 3 and 5 years⁵.

Valuation is nevertheless a primary building block of any team investment case. We believe that stocks which are clearly lowly valued relative to their fundamentals provide a good opportunity set for potential investment. Partly, this is informed by their historic outperformance as described above. This in turn is based on the underlying psychology of markets.

Behavioural biases create opportunities in markets to the benefit of disciplined long-term investors. Markets driven by greed and fear respectively tend to excessively bid up share prices on good news and similarly drive them down on the bad. The intrinsic value of a business tends to remain much more stable, creating divergences which opportunistic investors can exploit to their advantage.

An apparently low relative or absolute valuation is a useful starting place, but not a necessary condition for investment. We need fundamental analysis to gain confidence in our assessment of intrinsic value. As equity investors with a claim only on the profits of a business, we focus on normalised free cash flows.

An investment must offer compelling value not only relative to a company’s own history and peers, and the wider market, but must also stack up in absolute terms. We incorporate a range of factors into our analysis, including balance sheet leverage, long term competitive advantage and management quality. Such analysis ensures that an appreciable upside is based on more than speculation, as well as limiting downside risk potential to a tangible level which can be managed.

The third and final pillar of our investment philosophy is themes. A theme is a long-term driver of the investment case that is external to an individual business, that is expected to play out and interact with different companies across industries and geographies. These can be to the direct benefit of our investments, such as the shift to digitisation in technology and media.

Alternatively, they can be headwinds, such as the shift away from fossil fuels in the case of large oil & gas companies. Here though, our investment cases are predicated on those themes being mispriced, with declining demand rates overestimated and limited appreciation for the potential to offset that decline through investment in renewables, electrical distribution and carbon capture schemes. Correctly identifying these themes and the extent to which they are adequately reflected in share prices is one of the surest methods for avoiding value traps (stocks which look cheap relative to fundamentals but face an ever downward spiral of structural decline).

As the latter example suggests, “themes” is often where our value-driven approach focuses on Environmental, Social and Governance (ESG) issues. This is because the manner in which a company is run, how it is perceived by the public and – increasingly – the regulations which shape its operations are vital considerations in our assessment of intrinsic value.

Such ESG analysis sits alongside our role as stewards of our investments. Engaging with management to improve or in some cases simply showcase ESG strategy is one of the clearest ways in which we as active managers can realise value for both our clients and invested companies. Contrary to the typical view of value investors, we believe that our willingness to invest in companies that may not yet be best in class from an ESG perspective, but where those issues are improving and priced in, requires a far more detailed appreciation of ESG issues than simply dismissing them out of hand.

In AllianzGI’s UK equities team, we have taken this three-pronged approach to value investing for well over a decade across two strategies. Both the Allianz UK Listed Equity Income Fund and Allianz UK Listed Opportunities Fund, as well as The Merchants Trust, have benefitted from our value-driven approach across a broad range of market conditions. The result across products is an industry leading performance which defies more than ten years of value headwinds. Yet with the value style having recently proved a tailwind, prospective clients are already asking whether they have missed the boat. As a team, we are confident that the philosophy and practice our tried and tested approach should continue to benefit both new passengers, and those already settled aboard, for many years to come.

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_{1 Source: Morningstar, Allianz UK Listed Equity Income Fund—C (Inc) – GBP, IA UK Equity Income, net of fees, as at 31.03.2022. Benchmark: FTSE All Share Index. This fund uses the specified benchmark as a target. This means that the index shown is part of a target set for the fund’s performance to match or exceed. A ranking, rating or award is not an indicator of future performance and is subject to change over time.
2 Source: Bloomberg, MSCI World Value Index, MSCI World Growth Index, 31.12.2009-04.04.2022.
3 Source: Bloomberg, S&P 500 Index, 31.12.2009-31.12.2010, 31.12.2020-31.12.2021.
4 Source: Kenneth R French, Data Library, The Value Premium, Fama-Miller Working Paper, Fama/French, Jan 20, 2020.
5 Source: Morningstar, Allianz UK Listed Equity Income Fund—C (Inc) – GBP, IA UK Equity Income sector, and Allianz UK Listed Opportunities Fund – C (Acc) – GBP, IA UK All Companies sector, net of fees, as at 31.03.2022. Benchmark: FTSE All Share Index. These funds use the specified benchmark as a target. This means that the index shown is part of a target set for the fund’s performance to match or exceed. A ranking, rating or award is not an indicator of future performance and is subject to change over time. Past performance does not predict future returns.}

This is a marketing communication. For fund distributors and professional investors only. The views and opinions expressed herein, which are subject to change without notice, are those of the issuer companies at the time of publication.

Investing involves risk. The value of an investment and the income from it may fall as well as rise and investors might not get back the full amount invested. Allianz UK Listed Equity Income Fund and Allianz UK Listed Opportunities Fund are sub-funds of Allianz UK & European Investment Funds, an open-ended investment company with variable capital with limited liability organised under the laws of England and Wales. The value of the units/shares which belong to the Unit/Share Classes of the Sub-Fund that are denominated in the base currency may be subject to a strongly increased volatility. The volatility of other Unit/Share Classes may be different. Past performance does not predict future returns. If the currency in which the past performance is displayed differs from the currency of the country in which the investor resides, then the investor should be aware that due to the exchange rate fluctuations the performance shown may be higher or lower if converted into the investor’s local currency.

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