With government bond yields collapsing to multi-decade lows over the past few years, the equities with the most bond-like profit characteristics – and those deemed to be really high-quality growth – have been re-rated to higher and higher levels.
At the same time, new money for investments has been a bit thin on the ground, so much of the cash that has been invested in these types of stocks has been switches: money taken out of value-type stocks, companies that might have good business models but which are seen as less reliable.
As a result, a huge gap has opened up between the valuations of growth companies and bond proxies versus the lowly valuations of many value stocks. When this gap reduces, the value factor will become a tailwind and funds with these strategies should do particularly well.
What will be the catalyst for the rotation from growth to value? Some may say it has started already. Certainly, for the first time in a long time, some value funds have had a better run this year. However, for this trend to continue, it may take something like a move from monetary to fiscal stimulus – a move that may not be far off.
If that happens, then now could be a great entry point for funds of a value ilk. A fund I like that fits the bill is R&M UK Equity Long Term Recovery.
As the name suggests, the fund invests in recovery stocks. It has been run by Hugh Sergeant since 2008 and he defines recovery shares as those that are experiencing a depressed level of profits and share price, but have a strong business franchise and are showing clear signs of recovering those profits to a more normal level.
His view is that the profits of a recovery share are usually depressed due to either economic or industry dislocation or poor management decisions – or both – and that the catalysts for recovery are most often either self-help (frequently encouraged by new management) and/or revenue stabilisation.
He believes in meeting company management first to ensure they are the right people to set their company on a long-term recovery. For portfolio construction, he uses a strategy called ‘Potential, Value & Timing’ or PVT, enabling him to highlight stock opportunities and build positions based on River and Mercantile’s own bespoke analysis. The final portfolio will hold around 150-200 stocks.
It was reasonably well positioned for the Brexit vote, having taken profits last year in many of its UK domestic recovery stocks, which, according to Hugh, had done so well there seemed to be little upside left. This capital was recycled into new recovery ideas, notably global cyclicals such as resource stocks and emerging market-exposed companies. These are immature recovery investments at the beginning of their improving return on capital cycle.
The portfolio, in aggregate, is valued at only 1.2 times book value and has a 9 per cent cashflow yield, both far more attractive than the market.
Mr Sergeant has said recently that he believes the current environment represents the “best opportunity to buy value-type shares since the end of the TMT bubble in 2000”. If you agree, this fund could make a good addition to clients’ core portfolios.
Darius McDermott is managing director of FundCalibre
