InvestmentsAug 12 2013

Pros and cons of value investing

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But experts say there are some downsides to using this strategy, and that it is best incorporated into a broad portfolio.

While many managers claim to look closely at valuations, true value investors look for seriously devalued assets which they believe have been underestimated by the market. Reasons for sharp drops in share price vary, but it could be that the company has suffered a high profile setback, causing investors to panic. Value managers try to look for catalysts for a recovery in the stock’s intrinsic worth, such as a management change, and try to avoid stocks that are “cheap for a reason”.

Nick Kirrage co-manages the £378.9m Schroder Recovery fund, which invests in stocks that “have suffered a major profit or share price setback, but which appear to have good long-term prospects and the potential for significant share price gains”.

Mr Kirrage says investors who are brave enough to include a value fund such as this in their portfolio will do well in the long term, but have to be prepared for periods of underperformance which could last several years.

But the manager says that the fund can go through periods of volatility, and it is a challenge to keep investors on board who want to see a return on a shorter time horizon.

A lack of liquidity is often cited as a reason not to invest in “value,” as stocks that come under pressure from the market can drop drastically in size, making it difficult to move in and out of them.

Mr Kirrage agrees that this can be an issue with smaller vehicles, but argues that there can be “value hiding in plain sight,” with large stocks sometimes becoming undervalued; British American Tobacco’s share price went up more than 1000 per cent in a decade. There are several different ways that investors can access a value investment style.

Ian Barrass, manages the Henderson Value Trust with Paul Craig, an investment trust of open and closed-ended funds which uses its closed-ended structure as a way to gain access to less liquid and more esoteric assets with shares that have fallen to a significant discount to net asset value (NAV). “The key thing we look at is whether something genuinely represents value. It has got to be value for the right reasons – there are traps you can fall into,” Mr Barrass says

To avoid these pitfalls, there are strict criteria the managers use when deciding which funds to invest in. There must be a decent manager who knows how to “drive out value,” and the underlying assets must have potential for repricing, with any liquidity issues addressed.

A value style has some drawbacks: liquidity can be low in stocks that are performing poorly, and it is not always clear when a stock has hit its lowest point. But if investors select a discerning manager who can identify when there is a catalyst for a positive change for a stock’s price, growth forecast or dividend, they are usually set to receive a more impressive return than they would get with a less volatile style, as long as they are prepared to wait.

Eleanor Lawrie is news reporter at Investment Adviser