Fund managers dig deep to find value

Investors willing to wait for long-term profits from lowly-valued shares will soon be able to buy into the first ‘deep value’ investment trust to be launched in the UK. But while this strategy has proved popular in the US, advisers warn that highly “undervalued” companies can remain out of favour for a long time – and run the risk of bankruptcy.

This week, Church House Investment Management announced the launch of Trade & General Investments plc, a new investment trust that will take a specialist ‘deep value’ approach. Deep value investing involves buying into companies whose share prices have fallen to a steep discount to the value of their assets – but which demonstrate the potential to turn their performance around. Church House says its trust will target companies whose current market capitalisations have sunk below “realistic values” – and believes it is “the only investment fund of its kind in the UK.” However, manager Jeroen Bos brings more than 20 years’ experience of this investing style, having run an offshore deep-value fund that has returned 65.2 per cent in the past 5 years, compared with a 21.7 per cent rise in the FTSE All-Share index over the same period.

“In the current market environment, value investing will work well, as the strategy is less focused on expected earnings, and more geared towards buying assets at a discount,” Bos claims. “Using the disciplined approach of only buying shares of companies when they can be purchased at a discount to their balance sheet values, you are protecting yourself from paying too much at the outset, leaving capacity for significant investment growth.”

While similar deep value funds are widely available in North America, UK managers have until now preferred a more conventional form of value investing, based on shares that trade on low multiples of net assets but also pay dividends.

Justin Lowes, who runs the Elite LWM East-West Value Fund, an open-ended investment company, says a lack of dividends is the key difference between deep value investing, and the value investing practised by UK equity income fund managers. “Deep value funds are prepared to invest in securities whereby no dividend income is currently on offer, in the belief that there is tremendous potential for appreciation of the market price of the security,” he explains.

In some cases, that can mean buying into companies with insufficient profits to even consider dividends, says Adrian Lowcock, senior investment adviser at Bestinvest. “Deep value is where the share price of a company has collapsed, usually as a result of a shock event or a wipe-out of profits to such a point that the stock market is not convinced the company can survive.” If it can survive, though, investors stand to profit as its market value moves back towards its intrinsic value. “A stock with no yield is unlikely to be of interest to an equity income investor, whereas it may be of interest to a deep value investors if it is deemed to be trading well below asset or book value,” says Mick Gilligan, director of fund research at broker Killik & Co.

If the share price is far enough below the net asset value per share, any further downside can be limited, according to Anne Gudefin, portfolio manager at Pimco – which operates a proprietary deep value strategy called Pathfinder. “We want to buy an asset with a 30-40 per cent discount,” she says. “Because there is such a margin of safety, this limits the downside. Pathfinder is a strategy that focuses on capital protection. We are looking for companies with high quality assets. Occasionally, these companies trade cheaply, most of the time because their earning power has been temporarily impacted.” She cites BP, after the Gulf of Mexico oil spill last year, as an example.

But advisers warn that a deep-value strategy inevitably brings added risks.

“Companies in deep value are there for a reason: most investors do not think they will survive, and the risk is they won’t,” says Lowcock. “Just because a company looks deep value doesn’t mean it is, it could simply be bankrupt.” Even when lowly valued companies survive, they may not recover, adds Tom Becket, manager of the PSigma Balanced Managed Fund of Funds. “The real danger to the deep value approach is that deep value remains deep value for a long time. Investing in such a manner needs an incredible amount of patience and deep value managers can lose a lot of fingers ‘knife-catching’ stocks that keep falling.”

Tim Cockerill, head of collectives research at advice firm Ashcourt Rowan, says this puts all the onus on stockpicking ability. “The risk is in the analysis of the companies the manager buys,” he explains. “They need to get this right – otherwise you end up holding a fund invested in unloved, out of favour, poor quality stocks that no one wants.”

Pimco acknowledges these “value traps”, but believes fund managers can identify catalysts for recovery. Gudefin suggests new management, a restructuring programme, sales of non-core or non-performing assets, and strong free cash flow generation are all positive signs.

Whether private investors can wait for recovery is another risk, though. “Just because you buy something that is incredibly good value does not meant that it can’t fall a lot further in the short term,” admits Lowes. “Also, because deep value will often lead the investor into contrarian positions, you will regularly find yourself buying when most investors are fleeing on the back of short-term factors and concerns – when fear is in the ascendant. So the biggest risk is that investors in the strategy bail out due to emotional concerns. They choose the strategy for all of the right reasons but then do not have the emotional discipline to stay the course.”

As a result, advisers believe it is better to seek exposure to deep-value strategies via investment trusts, as their closed-ended structure means they are not forced to sell holdings if some investors decide to cash in their stakes. “Fund managers need to be able to concentrate on working closely with a small number of companies and given the time to turn things around,” argues Lowcock. “They cannot afford to be distracted by inflows and outflows.” Becket agrees that investment trusts seem the logical way of managing deep value strategies: “The fund managers would not be at the mercy of redemptions, which could force them to sell positions into a friendless market.”

At present, there are no other specialist deep-value investment trusts listed in the UK, but advisers note that some existing trusts adopt aspects of the strategy. Killik & Co favours the North Atlantic Smaller Companies Investment Trust, which typically invests in “sound businesses suffering from a temporary decline in profitability or mismanagement”. In addition, it suggests the Temple Bar Investment Trust, the British Empire Investment Trust and the Rights & Issues Investment Trust, which is also recommended by Bestinvest. Becket, however, prefers the contrarian, deep value approach of an open-ended fund: Investec Special Situations. “The bottom line is that, over the longer term, deep value is likely to do very well, whether via a closed or an open structure,” he argues.

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