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MAIN FEATURE Finding great value shares: How fund managers do it and how you can too
FINDING GREAT VALUE SHARES
HOW FUND MANAGERS DO IT AND HOW YOU CAN TOO
By Martin Gamble and Tom Sieber
THE IDEA BEHIND value investing is to buy shares for less than they are worth in the hope they reach their so-called ‘fair’ value and generate a better than market return.
This article explores popular yardsticks used to find value shares, explains how they are used and highlights the advantages and drawbacks.
Before starting it is worth bearing in mind that none of the metrics discussed are perfect and they should never be used in isolation. There is no substitute for in-depth research into a business.
THE HUMBLE PE RATIO
One of the more popular ways to look for value is the PE (price to earnings) ratio which has the advantage of being easy to calculate. Simply divide the current share price by the forecast earnings per share.
For example, premium brand alcoholic beverage company Diageo (DGE) is expected to deliver 174p of earnings per share for the year ending 30 June 2023. Its share price of £36.66 implies a forward PE ratio of 21 times.
THE MERCHANTS TRUST – FOCUSED ON DIVIDENDS SO YOU CAN FOCUS ON LIFE
The Merchants Trust aims to provide an above average level of income that rises over time. So whilst we focus on investing in large UK companies with the potential to pay attractive dividends, you can focus on travel, family, home, retirement – whatever matters to you. Although past performance does not predict future returns, we’ve paid a rising dividend to our shareholders for 40 consecutive years. Beyond a focus on dividends, Merchants offers longevity too. Founded in 1889, we are one of the oldest investment trusts in the UK equity income sector. To see the current Merchants dividend yield, register for regular updates and insights, or just to find out more about us, please visit us online.
Looking through the FTSE 350 index the highest rated company is cyber technology firm Darktrace (DARK) with a forward PE of 73 times while the cheapest is oil and gas company Harbour Energy (HBR) which trades on three times next year’s earnings.
It would take 73 years of cumulative current profit to recoup your original investment in Darktrace while only three years from investing in Harbour Energy.
This implies investors expect lots of earnings growth at Darktrace and perhaps falling earnings at Harbour Energy. So, while a low PE can indicate good value, it is important to think about what growth is implied. Does it seem reasonable or not?
Another useful way to use the PE ratio is to compare it with either a firm’s own history or the sector average.
Studies have shown the PE to be mean reverting which simply means it moves up and down around a long-term average. Shares trading significantly below the average are considered cheap and those above expensive.
PEG RATIO
The PEG or PE to earnings growth ratio adds a growth element to the humble PE. Simply divide the forward PE by expected earnings growth. The idea is to find companies which trade on a PE ratio below their sustainable growth rate.
For example, tobacco company Imperial Brands (IMB) is expected to grow its earnings by 30% in the year to 30 September 2023 to 293p per share. The current share price of £21.15 implies a PE of 7.2.
Therefore, the company trades on a PEG ratio of 0.24. It seems unlikely the Imperial Brands can sustainably grow earnings at 30% a year, so some caution is required when interpreting the results.
A ratio of one indicates a stock is ‘fair’ value, a ratio between 1 and 0.5 is considered good value while a ratio below 0.5 is considered excellent value.
The ratio is often used by growth-oriented fund managers looking to find growth at a decent price rather than pure value-style managers.
PRICE TO BOOK VALUE
Book value is shareholders’ capital and sometimes referred to as net assets. It is calculated by taking a company’s total assets minus total liabilities.
Let’s take housebuilder Barratt Developments (BDEV) to illustrate how this works. It has total assets of £8.2 billion and total liabilities of £2.58 billion which means it has net assets of £5.62 billion.
There are 1.023 billion shares outstanding which equates to 549p of book value per share. At the current price of 401p the shares trade at a discount of 27% or a price to book of 0.73.
In general, any value below one is considered cheap, but in practice shares can trade below book value for good reason.
As explained at the beginning, such tools are only the starting point for further analysis. There could be fears, for example, that housebuilders will be forced to ‘mark down’ their land values if the UK property market suffers a big fall in prices.
Price to book is often used in specific sectors such as banks, insurance companies, housebuilders, property firms and investment trusts.
OUT OF FASHION
Things like land, property, machinery, and furniture are called tangible assets. In other words, they can be seen and touched.
The price to book ratio is arguably a less useful metric of value for companies which do not employ a lot of physical assets, such as technology firms.
The asset base of many successful firms today is comprised of intangible assets. These can be things like patents, brands, trademarks, copyrights, customer lists, and knowhow or intellectual property.
This makes it harder to measure capital in the modern economy and by inference relegates the usefulness of the price to book ratio as a reliable measure of value for some sectors.
FREE CASH FLOW YIELD
Some investors see cash flow as a more appropriate measure of value than earnings or book value. After all, shareholders have a claim on all future cash flows.
One of the main advantages of cash flow is that it is harder to manipulate than earnings or book value.
Free cash flow is operating cash minus capital expenditure or capex. Operating cash is what is left after deducting all operating expenses, and financial charges.
To calculate a free cash flow yield, you can divide free cash flow by market capitalisation then multiply by 100 to get a percentage. Most companies give free cash flow in the annual accounts. Some people prefer to use enterprise value (incorporating a firm’s net cash or net debt) when calculating the free cash flow yield.
Food-on-the-go sausage roll company Greggs (GRG) reported cash from operations last year of £286 million while capex was £54 million, equating to a free cash flow of £232 million.
The current market cap of Greggs is £2.26 billion which means its free cash flow yield is 10.2%.
Software services such as Sharepad and Stockopedia also provide free cash flow yields.
Higher yields represent better values. Some investors use 10-year bond yields as a hurdle comparison. With 10-year gilts yielding around 4% only companies offering more than 4% free cash flow yield are seen as good value.
STRIPPING OUT MAINTENANCE CAPEX
Unlike the metrics discussed so far, the free cash flow yield is often used by both value managers and growth managers.
For example, investment manager and founder of Fundsmith, Terry Smith is fond of the metric. But Smith makes an adjustment to free cash flow where he deducts ‘maintenance’ capital expenditures from operating cash flow rather than total capex.
His reasoning is that companies should not be penalised for spending money to grow the business. After all, that is precisely what he wants to see, so long as it earns a good return.
Stripping out growth capex increases free cash flow and free cash flow yield.
Maintenance capex is the amount of spending needed to keep a company competitive. The problem is, not many companies split capex in this way, so investors need to make an educated guess.
One company which does explicitly separate out maintenance capex is gym operator Gym Group (GYM:AIM).
A rough proxy for maintenance capex is the annual depreciation charge which can be found in the accounts.
EV TO EBITDA
The EV/EBITDA (enterprise value to earnings before interest, tax, depreciation and amortisation) metric is popular with analysts and investment bankers. Its main advantage is that it can be used to compare companies in the same sector which have different financing structures.
It is also important in mergers and acquisitions
why companies might trade below book
• Illiquid assets – i.e. they may not be easy to sell quickly • The assets may be difficult to value • The assets may be overvalued • Concerns among investors that the assets are falling in value • The assets aren’t generating a good return • Selling the assets would create a tax liability
because EV or enterprise value represents the total amount of funds a company needs to secure to proceed with a takeover. Enterprise value is the total value of a business including its net debt or net cash. Net debt is added onto the market cap, net cash is subtracted from it to calculate the EV. EBITDA is a proxy for cash flow. Its disadvantage is that unlike cash from operations EBITDA does not include finance costs. In addition, it doesn’t take account of depreciation or amortisation costs.
Gambling sector EV-to-EBITDA comparison
Name
Rank 888 Entain Flutter Entertainment
EV (£bn) EV/EBITDA (x)
0.49
2.22
7.76
19.70 4.08
5.84
EBITDA =Earnings before interest, tax, depreciation and amortisation. EV=Enterprise value Table: Shares magazine • Source: Shares magazine, company accounts, Shore Capital 9.58
14.70
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The Merchants Trust PLC
The Merchants Trust aims to provide an above average level of income that rises over time. So whilst we focus on investing in large UK companies with the potential to pay attractive dividends, you can focus on travel, family, home, retirement – whatever really matters to you. Although past performance does not predict future returns, we’ve paid a rising dividend to our shareholders for 40 consecutive years, earning us the Association of Investment Companies’ coveted Dividend Hero status. Beyond a focus on dividends, Merchants offers longevity too. Founded in 1889, we are one of the oldest investment trusts in the UK equity income sector. To see the current Merchants dividend yield, register for regular updates and insights, or just to find out more about us, please visit us online.
www.merchantstrust.co.uk
INVESTING INVOLVES RISK. THE VALUE OF AN INVESTMENT AND THE INCOME FROM IT MAY FALL AS WELL AS RISE AND INVESTORS MAY NOT GET BACK THE FULL AMOUNT INVESTED. A ranking, a rating or an award provides no indicator of future performance and is not constant over time. You should contact your financial adviser before making any investment decision. This is a marketing communication issued by Allianz Global Investors GmbH, an investment company with limited liability, incorporated in Germany, with its registered office at Bockenheimer Landstrasse 42-44, D-60323 Frankfurt/M, registered with the local court Frankfurt/M under HRB 9340, authorised by Bundesanstalt für Finanzdienstleistungsaufsicht (www.bafin.de). The summary of Investor Rights is available at https://regulatory.allianzgi.com/en/investors-rights. Allianz Global Investors GmbH has established a branch in the United Kingdom deemed authorised and regulated by the Financial Conduct Authority. Details of the Temporary Permissions Regime, which allows EEA-based firms to operate in the UK for a limited period while seeking full authorisation, are available on the Financial Conduct Authority’s website (www.fca.org.uk).
WHERE FUND MANAGERS FIND VALUE AND WHAT THEY’VE BEEN BUYING IN 2022
As the first part of this article has amply illustrated there are different ways of identifying value and the term doesn’t necessarily mean the same things to different people.
Shares has spoken to various managers of investment trusts with a value focus or an emphasis on finding stocks on attractive valuations to discover how they define value, how they uncover bargains and the names they have been snapping up recently.
HOW DO FUND MANAGERS DEFINE VALUE?
Joe Bauernfreund, the manager of AVI Global Trust (AGT), takes things right back to brass tacks. He says: ‘At its simplest, value investing means buying something for less than it’s worth.’
Merchants Trust (MRCH) manager Simon Gergel adds: ‘For equities we aim to buy fundamentally strong businesses, which benefit from positive structural or thematic drivers, and that are cheap versus their history, peers or the broader market.’
Laura Foll who helps steer the Lowland Investment Trust (LWI) notes when her team talk about a firm being attractively valued they mean that on ‘balance of probability’ it is capable of achieving greater sales and earnings growth than implied by the share price.
Temple Bar (TMPL) manager Ian Lance defines value investing as ‘the purchase of something for significantly less than a conservative estimate of its intrinsic value.’
He goes on to say: ‘Strangely we would have thought that should just be the definition of “investing”. “Quality” refers to the characteristics of the business you are buying whilst growth is an input into the calculation of value, but the purchase of quality or growth businesses in the absence of valuation has historically led to poor investment returns.’
Co-manager at Mid Wynd International (MWY) Alex Illingworth looks for value, but tries to avoid value traps, so he assesses not just how a company is priced but its growth potential and threats to cash flow. ‘The most obvious one today is rising interest rates, which can make the cost of debt very painful. But there are other threats.’
Amazon
2018 2019 2020 2021 2022 2023
Chart: Shares magazine • Source: Refinitiv
Illingworth highlights the example of Amazon (AMZN:NASDAQ) which is valued on the basis it might one day have to pay the rate of tax most people think it should.
Odyssean Investment Trust (OIT) takes a slightly different approach, applying private equity skills to invest in what it calls ‘misunderstood companies’. ‘Our approach to value is based on the team’s combined private and public equity experience,’ says manager Stuart Widdowson.
First up the Odyssean team consider the ‘static’ value of the business – including the likely value a trade buyer or private equity investors would place on a business to buy it.
‘We believe that our private equity and M&A experience means we are better placed than many equity fund managers in evaluating the attractiveness of quoted companies to potential private equity and trade bidders, and how these bidders are likely to value these companies,’ adds Widdowson.
Second, Odyssean looks at ‘dynamic value’ or how the value could change over the next three to five years, identifying five levers that companies can pull to unlock value including: growing sales organically; improving margins; generating surplus free cash flow; a rerating in the shares; and M&A.
WHAT METRICS DO MANAGERS USE TO IDENTIFY VALUE?
Among the simplest and most consistent approaches is that pursued by Joe Bauernfreund at AVI Global Trust, something which is replicated across parent investment manager Asset Value Investors, namely investing in firms trading at a discount to net asset value.
‘More holistically, we recognise that value for value’s sake – or simply focusing on wide discounts – is not enough. We are focused on buying high quality assets, the value of which will likely grow over time, at discounted valuations,’ Bauernfreund says.
Widdowson at Odyssean says his emphasis is on long-term enterprise value (which is the market cap plus net debt) to sales ratios, enterprise to operating profit, price to earnings, free cash flow yield and price to book.
‘When earnings are volatile or depressed in a company which is in a recovery phase, we tend to focus much more on enterprise value to sales and price to book ratios, which are more consistent valuation metrics and less prone to manipulation than earnings,’ he explains.
Gary Channon at Aurora Investment Trust (ARR) focuses on a metric called CROCC or cash return on core capital. Core capital is defined as the capital you would need to replicate the business in question.
Channon observes this is typically fixed assets plus working capital, adding ‘then we look at what clean cash return is made on that capital’. He adds: ‘This removes all the intangible and non-cash accounting noise and the effect of past acquisitions and shows truly whether at its core the business activity generates high returns.’
Mid-Wynd International’s Illingworth says traditional value investing is always derived from the balance sheet. ‘Beyond, and separate from our cash flow valuations, we also look to the balance sheet to assess the cost of rebuilding the franchise the company has created.
‘To do this we factor in intangible assets – like the value of a brand. The accounting equivalent of this is goodwill, but that isn’t always very accurate. We’ll do some quite complicated calculations to put a value on intangible assets.
‘The whole two-part process allows us to assess
traditional (balance sheet) value as well as value implied by the cash flows.’
Lowland’s Laura Foll makes the salient point that different metrics are sometimes suited to different industries. For example, she uses price to book for banks and for industrial companies she tends to favour enterprise value to sales.
WHAT HAVE MANAGERS BEEN
BUYING ON 2022 WEAKNESS?
As AVI Global’s Bauernfreund observes: ‘Whilst painful in the short term, market volatility and panic are our friends – sowing the seeds for longterm performance.’
Many of the managers Shares has consulted have used the volatility and market weakness seen in 2022 to buy discounted stocks.
Odyssean’s Widdowson says the company recycled cash from media business Euromoney (ERM), following its £1.6 billion takeover by Becketts Bidco, into Ascential (ASCL) which Widdowson says is ‘a similar sized B2B media company, whose shares had more than halved in value despite maintaining forecasts’.
He observes that, like Euromoney, at the trust’s entry price the shares were trading at a substantial discount to its view of the sum of parts valuation.
Widdowson also secured an ‘extremely undemanding’ entry valuation in diversified services group James Fisher (FSJ). He expects the end markets served by the business to recover after a terrible two years which, alongside management initiatives, should aid a recovery in earnings and the balance sheet.
Gergel at Merchants Trust says there have been various situations where share price declines have allowed him to buy strong businesses at attractive prices. ‘Unilever (ULVR) is a strong, defensive company that was oversold in the spring, and we bought it for the first time in many years.
Ascential
(p)
400
300
200
2018 2019 2020 2021 2022 2023
Chart: Shares magazine • Source: Refinitiv
Unilever
(p)
5,000
4,000
3,000
2018 2019 2020 2021 2022 2023
Chart: Shares magazine • Source: Refinitiv
‘We also bought the building materials supplier Grafton (GFTU), real estate company CLS (CLS), and some companies we had owned before but became attractive again, like CRH (CRH) and National Express (NEX).’
Channon says Aurora has been buying where
his team have found the most value within their circle of competence. This includes what he describes as ‘cyclical UK-centric businesses’ like UK housebuilders Barratt Developments (BDEV) and Bellway (BWY) and online businesses which benefited from the pandemic but are now struggling like AO World (AO.) and Netflix (NFLX:NASDAQ).
Netflix
2018 2019 2020 2021 2022 2023
Chart: Shares magazine • Source: Refinitiv
He adds: ‘This looks like one of the great valuebuying windows because we are able to buy at prices where we see 200% of upside to intrinsic value.’
Pursuing value doesn’t necessarily mean buying outright bargain-basement stocks, reflected in Swiss/American firm Mettler Toledo (MTD:NYSE) – highlighted by Mid Wynd manager Illingworth.
A world leader in specialised weighing scales for labs and supermarket self-service tills, it was long admired by the Mid Wynd team. With its rating having fallen from 40 times earnings, the trust picked up shares at the much lower rating of 27 times earnings.
Laura Foll at Henderson says Lowland has invested in Cranswick (CWK) this year. ‘It is a market leader in pork in the UK and is gradually expanding in chicken supply as well. While this is not a particularly glamourous industry, Cranswick is better invested than its peers and therefore capable of making an above-peer margin. It is taking the knowledge learned from pork over many years and applying this to poultry, where it is taking market share.
‘There is the potential for it to go significantly further, providing a pathway to long-term earnings growth if successful. From a valuation perspective, the shares are trading at a substantial discount to their five and 10-year average valuation.’
Cranswick
(p)
4,000
3,500
3,000
2,500
2018 2019 2020 2021 2022 2023
Chart: Shares magazine • Source: Refinitiv
THE VALUE IN VALUE
ALEX WRIGHT, FIDELITY SPECIAL VALUES
Over the past decade, we have experienced a prolonged period of very subdued inflation, low interest rates and modest economic growth. This has been an environment which has very much favoured growth companies at the expense of attractively valued companies with lower downside risk that we favour. We believe the current market environment of higher and stickier inflation, rising interest rates and greater economic volatility is more representative of the longer-term pattern seen over the last 100 years. History suggests that over the long-term, value tends to outperform given generally higher discount rates and a reversion to the mean. By targeting unloved stocks on depressed valuations and leveraging Fidelity research resources, I believe value as a style could outperform growth over the next decade.
A dedicated follower of the unfashionable
FIDELITY SPECIAL VALUES PLC
This investment trust seeks out underappreciated companies primarily listed in the UK, whose quality and long-term growth potential have been overlooked by the market.
Those who have held on to their vinyl records over the years, will understand why investing in what’s not in vogue can pay off. It’s something the trust’s portfolio managers appreciate, too. Supported by an extensive research team, they look to invest in out-of-favour companies, having spotted potential triggers for positive change they believe have been missed by others. It’s a consistent and disciplined approach that has worked well; the trust has outperformed the FTSE AllShare Index over the long term, both since the current manager took over in September 2012 and from launch over 27 years ago. As with vinyl, the true value of a good company is almost always recognised in time, even if it temporarily falls out of fashion.
The value of investments can go down as well as up and you may not get back the amount you invested. Overseas investments are subject to currency fluctuations. The trust can use financial derivative instruments for investment purposes, which may expose it to a higher degree of risk and can cause investments to experience larger-thanaverage price fluctuations. The trust invests more heavily than others in smaller companies, which can carry a higher risk, because their share prices may be more volatile than those of larger companies and the securities are often less liquid.
PAST PERFORMANCE
Jul 2017 –Jul 2018 Jul 2018 –Jul 2019 Jul 2019 –Jul 2020 Jul 2020 –Jul 2021
Jul 2021 –Jul 2022
Net Asset Value 9.5% -2.5% -24.0% 51.6% 4.3% Share Price 16.6% -3.5% -31.1% 66.6% -0.8% FTSE All-Share Index 9.2% 1.3% -17.8% 26.6% 5.5%
Past performance is not a reliable indicator of future returns.
Source: Morningstar as at 31.07.2022, bid-bid, net income reinvested. ©2022 Morningstar Inc. All rights reserved. The FTSE All-Share Total Return Index is a comparative index of the investment trust.
