Thinking differently

Financial markets can be inefficient in the short term, driving share prices away from their true fundamental value. This can create interesting long-term opportunities for disciplined “value” investors that are prepared to challenge consensus beliefs. Here, we take a look at The Merchants Trust, which is managed by Simon Gergel who has been successfully deploying such an approach for more than 30 years…

The value investor – exploring the benefits of being prepared to think differently

“In the short run, the market is a voting machine, but in the long run, it is a weighing machine.”

This timeless quote from Ben Graham, one of the greatest investors of the 20th century, captures the essence of value investing, a strategy that rationally questions prevailing market sentiment. The quote implies that the influence of emotion can make financial markets inefficient in the short term, driving share prices away from their true fundamental value¹.
 

“In the short run, the market is a voting machine, but in the long run, it is a weighing machine.”

 
By maintaining a disciplined, independent mindset and challenging consensus beliefs, the value investor can take a contrarian view to identify situations where share prices have become detached from fundamentals and invest in undervalued assets that have the potential to shine brightly in the long run.

Simon Gergel, portfolio manager of The Merchants Trust, has been successfully deploying a value investment approach for more than 30 years. His aim is to identify good quality businesses and invest in them when they are out of favour. Their temporary lack of popularity tends to be reflected in lower share prices and valuations, as Simon explains:

“When there’s an issue affecting sentiment, it can provide a great opportunity to buy good companies cheaply. If investors are nervous about a business, industry, or even the economy more broadly, it will tend to mean lower share prices. As long as we can become confident the issues that are affecting sentiment are temporary rather than permanent, this can represent a really attractive entry point.”
 

A long-term mindset

 
As Ben Graham’s quote suggests, successful value investing demands a long-term investment horizon. The swings in sentiment that create short-term market inefficiencies should, ultimately, be replaced by a more appropriate assessment of intrinsic value as the market becomes an effective weighing machine over time.
 

‘successful value investing demands a long-term investment horizon’

 
Indeed, swings in sentiment work in both directions, under-valuing businesses when they are out of favour, and over-valuing them when they are popular.

“The stock market tends to overvalue companies when they are doing well because their shares become very popular. There are all sorts of behavioural reasons why this is the case – the fear of missing out, the comfort of the crowd, or recency bias where investors anchor to recent information rather than a broader long-term context. We see these behavioural biases time and time again in markets, and it’s why we occasionally see asset price bubbles forming.”
 

 

Thinking differently

Value investors, by their very nature, have to be prepared to think differently to the consensus. This requires discipline and the ability to detach oneself from the emotions that can accompany investment decisions.
 

‘a lot of work goes into every investment decision, to build conviction in an investment case that challenges the consensus’

 
This isn’t as easy as it sounds, and it can be a lonely pursuit, as Simon explains:

“I have to be prepared to be different and be prepared to stick with it. Buying shares when they are depressed or going down – and selling shares when they’re on the up – means generally heading in the opposite direction to the majority, so I have to be absolutely convinced that it’s the right thing to do. This means a lot of work goes into every investment decision, to build conviction in an investment case that challenges the consensus.”
 

Side Notes – Receding challenges

 
In the wake of a number of challenges to the UK stock market in recent years, Merchants’ Portfolio Manager Simon Gergel looks at how those challenges and headwinds look to be falling away and what that may mean for markets, particularly if one of the more recent headwinds, higher interest rates, do indeed start to fall.
 

 

Building conviction

 
UK housebuilders are an example of where the team has been thinking differently recently. Share prices were generally weak for much of 2023, as the stock market worried about the impact of a potential recession and higher interest rates on the UK housing market. Whilst this is understandable, value investors like Simon are prepared to take a longer-term view of the industry. In doing so, Simon has seen some very attractive fundamental characteristics in select companies.
 

‘the UK housing market looks well underpinned and some housebuilders also possess very attractive financial characteristics’

 
“The share prices of UK housebuilders have been under pressure because people are naturally concerned about the economic environment and what it may mean for the UK housing market in the near term. On a three-to-five-year view, however, we see very robust demand for housing and limited supply, which should support profits for the industry. The UK has a large, growing population, a shortage of housing and a limited supply of new homes coming to the market. From a medium-to-long-term fundamental perspective, therefore, the UK housing market looks well underpinned and some housebuilders also possess very attractive financial characteristics.”
 

Market-beating potential

 
Successful value investing provides the opportunity for investors to enjoy good long-term returns. By identifying good businesses and investing in them when they are out of favour, while at the same time avoiding stocks that look overvalued, investors can capitalise on the market’s inherent inefficiency. Clearly, it’s not without risk. Sentiment can remain against the value investor in the short-term and markets can continue to defy rational expectations for longer than we may expect. But, as Ben Graham said, there is the potential to do well from a disciplined, value investment approach, as the market ultimately focuses on its task of weighing the fundamental attractions of individual businesses appropriately.
 

‘Successful value investing provides the opportunity for investors to enjoy good long-term returns’

 
Under Simon Gergel’s management, investors have seen the benefits of his approach represented in a significant outperformance of the UK stock market index. Whilst past performance does not predict future returns, since Simon’s appointment as portfolio manager in May 2006, Merchants shareholders have seen a Net Asset Value (NAV) total return of 6.41% per annum, which compares favourably to the 5.74% per annum delivered by the FTSE All Share Index².

Simon, and fellow portfolio managers Richard Knight and Andrew Koch, are confident that by deploying the same disciplined approach and a willingness to invest away from the crowd, they will continue to find attractive long-term investment opportunities with the potential to meet Merchants’ objectives. After all, as another legendary investor, Sir John Templeton once said, “It is impossible to produce a superior performance unless you do something different from the majority.”
 

 
_{1 Fundamental value is the genuine intrinsic worth of a company, as determined by factors such as the estimated value of the future cash flows it will generate, or the value of the assets on its balance sheet.
2 Source: Data Stream 31/05/2006 to 31/01/2024}
 

Glass half full?

There have been many reasons over recent years for investors to be ‘out of love’ with the UK; Brexit, political uncertainty, pandemic, Ukraine, Trussonomics and the perception of worse inflation & economic performance for the UK to name a handful. But, has the depressed sentiment been overdone? In this podcast the team discuss that with many of these factors firmly in the rear-view mirror, and with interest rates potentially close to their peak and UK economic growth recently being revised upwards, could the glass actually be half-full, rather than the pessimistic alternative?
 

 
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