Value investing comes back into vogue

The celebrated value investor Warren Buffett stepped back on to the investment trail this week as his parent company Berkshire Hathaway injected SFr3bn ($2.6bn) in fresh capital into the struggling insurer Swiss Re.

The deal, which will pay Buffett hefty annual interest and give him the right to raise his stake at an attractive price, is a sign that the billionaire investor has not lost his appetite for financial stocks.

It also offers more evidence to suggest Buffett is keen to increase his investments in businesses that have been hit by the financial crisis but still have franchises. Last year, he invested $5bn in Goldman Sachs and $3bn in General Electric.

Buffett’s interest in Swiss Re also bolsters the confidence of the long-only value fund managers now setting off on buying sprees – in spite of the sustained slump in equities – on the view that an increasing number of companies are cheap.

“There are a growing number of momentum signals suggesting a market bounce,” says Robert Jukes, an equity strategist with Collins Stewart Wealth Management.

“One of the clear lessons from previous market recoveries has been the outperformance of value stocks in this environment.”

A value stock is one
that is relatively cheap compared with its assets and earnings. So, value investing, one of the oldest investing styles, means looking for bargains.

In the volatile markets of the past year, however, value stocks have suffered as the “value” of company assets and earnings has been rapidly revised downwards.

During this time, growth stocks, which have above-
average increases in revenues and earnings, have returned to favour. Last year, the S&P 500 growth index dropped 37 per cent while the S&P 500 value index lost 42 per cent.

But value enthusiasts claim the balance is beginning to shift.

“There are some tremendous opportunities at the moment,” says Neil Woodford, manager of Invesco Perpetual’s Equity income fund. “Many high-quality businesses are trading at extremely depressed valuations.”

Nick Sheridan, manager of The New Star European Value fund, agrees: “The last 18 months have not been conducive to success for a value approach but it is
this very underperformance that historically has been a precursor to strong outperformance. With the general equity market looking good value, the case is even stronger for value stocks, by definition the cheaper end of the market, to lead the recovery.”

Investors can use different methods of identifying whether a company is trading below its intrinsic value. These include screening for low p/e ratios (the ratio of a company’s share price to its earnings per share) or low price-to-book values (the ratio of a company’s share price to shareholders’ equity, excluding goodwill and other intangible assets) or high dividend yields.

Within the FTSE 100, a growing number of companies qualify. Screening to find companies with a dividend yield of more than 4 per cent, dividend cover of 1.5 times and a free cash flow yield of more than 5 per cent turns up British Aerospace, BAE Systems, Pearson (owner of the Financial Times), and Royal Dutch Shell, for example, according to Chris White, a UK equity fund manager at Threadneedle.

Tineke Frikkee, who oversees Newton’s Higher Income fund, has stakes in BP, Royal Dutch Shell, Xstrata, BHP Billiton and Vodafone as
well as select utilities. Dividend yields from these companies are expected to pay between 5 and 8 per cent for 2008 and increase even further this year. Sterling’s weakness has also bolstered the balance sheets of UK companies earning revenues in dollars.

The key to successful stock picking, say managers, is to distinguish between companies that are simply out of favour with the market and those with poor prospects.

“We can pick up some really high-quality businesses that trade at low multiples that give you a strong, sustainable and in many cases, growing dividend; that’s a huge opportunity,” says Paul Boyne, manager of Invesco Perpetual’s new global equity income fund.

European and US value stocks also look attractive. Robert Siddles, manager of F&C’s US smaller companies fund, is screening the agriculture, defence and healthcare sectors to find them – as well as looking in niche areas such as nursing.

And in another optimistic sign, the Russell 2000, the leading barometer of the health of the US small-cap market, has climbed higher than 440 after hitting bottom at 385 in November.

“Value has begun to do well again in the US as many expect it will be the first
out of recession,” says Siddles.

Income stocks in Europe are also rebounding, with European equities now yielding about 5.6 per cent on average compared with a 4.4 per cent yield from UK equity income stocks, according to Oliver Ross, manager of Ignis Argonaut’s European Income fund. In addition, European yielding stocks offer exposure to a wider range of companies.

“As banking dividends are cut in 2009, the investable universe of UK dividend stocks will contract even further,” Ross says.

“But in Europe, the arena is larger and extends from the petrodollar Norwegian economy to German manufacturers.” The euro’s sustained rise against the pound should help investors who are already committed to the market.