Interactive Investor

15 cheap shares value fund managers are backing

8th June 2022 09:11

Faith Glasgow from interactive investor

Value stocks have been benefiting from the market rotation, but fund managers argue plenty of bargains remain. Faith Glasgow reports on the shares the pros are seeing plenty of value in.

After a decade or more in the wilderness, value stocks have been proving much more resilient than their high-growth focused peers in the face of global market disruption this year.

To put that into context, the MSCI World Value Index has lost around 3.3% in 2022 so far (to the end of May), compared with a painful fall of 12.8% for the broader MSCI World Index.

A correction was already under way in 2021, away from the overheated growth sectors that boomed during the past years of ultra-cheap borrowing and a subsequent online lockdown existence, and back towards the wide selection of ‘conventional’ stocks offering good value. But it has been dramatically fuelled this year by the toxic combination of inflationary pressures in the aftermath of the pandemic, war in Ukraine and Covid shutdown in China.

As a consequence, investors in long-suffering ‘value’ funds – which look for relatively underpriced shares in terms of investment metrics such as the price/earnings (P/E) and price/book (P/B) ratios – have been enjoying their moment in the sun, or at least out of the worst of the storm.

​​​​​Are there now less cheap shares to find? 

But with the rotation towards value now well established, are fund managers with a value mandate getting to a point where good opportunities are hard to find?

Not according to Ian Lance, manager of Temple Bar (LSE:TMPL) investment trust. “Average value rallies last for approximately five years, and hence we think we are nearer the start than the end of this one,” he comments.

So in which areas are value stock-pickers now building positions? As Alex Wright, fund manager of Fidelity Special Values (LSE:FSV), points out, UK equities remain undervalued relative to global markets and reasonably valued in absolute terms, so this might be considered the obvious market to concentrate on. But it’s important to remember that there’s no ‘one-size-fits-all’ approach to value investing, as our round-up of manager perspectives makes clear.

For Job Curtis, manager of the City of London (LSE:CTY) investment trust, a member of interactive investor’s Super 60, reliable income is a key driver. As well as attractive valuations, therefore, he is on the lookout for good cash generation and sustainable profits from the mainly UK companies in which he invests.

Where City of London IT is finding opportunities

Curtis picks out the pharmaceutical sector as an interesting hunting ground with “reasonable valuation and innovative companies”.

“Pharmaceutical companies with patented medicines are well positioned for sustainability of profits, but they need to be innovative to discover new medicines to replace the old ones when those patents expire,” he explains.

In addition, ‘big pharma’ is well-placed to weather the current macroeconomic challenges: not only are these global businesses with a US focus, but healthcare is relatively resilient in the face of the squeeze on consumer spending, in that much of it is funded by government or by private medical insurance.

City of London already holds both AstraZeneca (LSE:AZN) and GSK (LSE:GSK), but Curtis has recently taken a position in the French pharma business Sanofi (EURONEXT:SAN). He outlines its attractions: “Sanofi is on a very reasonable P/E ratio for 2022 of 13.5 times, with earnings growth of 12% driven by Dupixent, a new treatment for dermatitis. Its dividend yield is 3.2%, with the dividend twice covered by earnings.”

​​​​​​Energy shares still going cheap

For Temple Bar’s Lance, the energy sector offers great opportunities in the hunt for high-quality, undervalued UK businesses with strong balance sheets. For a start, although Temple Bar's positions in Shell (LSE:SHEL), BP (LSE:BP.) and TotalEnergies (LSE:TTE) were established during the depths of the pandemic, current valuations remain “incredibly compelling” in the face of record profits as the Ukraine war disrupts global supplies.

Lance gives an example: “Even if the oil price were to fall back from current levels of around $110 to $70 a barrel, these companies would be valued at free cash flow yields of around 15% – and much of this cash is being returned to shareholders by way of dividends and share buybacks.”

That’s borne out by Janus Henderson’s latest Global Dividend Monitor. It reports an 11% surge in global payouts for the first quarter of 2022, with oil companies, alongside miners, leading the way. Oil companies saw dividends rebound by 32%, having cut them during the pandemic.

Moreover, says Lance, oil companies offer great inflation protection, because their revenues reflect household energy bills, which are a key component of inflation indices such as the consumer price index. When bills go up as inflation hits, energy stocks feel the benefit. An additional strength underpinning these stocks is that there has been so little investment in recent years. He adds: “Too much capital has come out of the industry in the last decade, creating supply constraints.”

Consumer cyclicals are also on the Temple Bar shopping list, on the grounds that “consumers have overreacted to the likelihood of a recession and are pricing these businesses on low multiples of low earnings”. Lance argues that while a recession may well be on the cards, it’s sensible to take a long-term view of companies’ earning power, rather than simply looking at what could happen in coming months. He likes companies such as ITV (LSE:ITV) and Currys (LSE:CURY) on this basis.

Like City of London, Murray International (LSE:MYI) investment trust has a strong income focus, but it takes a highly diversified global perspective. Manager Bruce Stout’s mandate is to grow payouts above the rate of inflation, covering dividends from the underlying portfolio rather than dipping into capital, and to deliver capital growth. The trust is also a member of interactive investor’s Super 60 list.

‘Growth mania’ has come to an end

Stout makes the point that in the past year’s shift away from growth stocks, all that has happened is that investor interest has broadened out beyond the market’s recent obsession with companies rooted in the various iterations of the gig economy and online life. Such businesses don’t have the earnings and cash flow Stout seeks, so he did not follow the crowds into them in the first place.

The market is not of interest to us; what’s interesting to us is what we can find that will deliver our mandate,” he says.

Over the past two or three years of ‘growth-mania’ - particularly in 2021 – Stout has been able to build up positions in a diverse range of less fashionable but robust companies worldwide at “very nice prices”.

In the face of strengthening inflation, the focus has been on real assets that provide at least a degree of protection against rising prices, from Canadian pipeline company TC Energy (TSE:TRP) to Grupo Aeroportuario del Sureste (NYSE:ASR), which owns Cancun Airport and is now the portfolio’s largest holding.

“Now, as opposed to two or three years ago, we’ve got lots of real assets that we can value,” Stout says. “There are so many businesses out there that can’t be valued - they are great concepts and were widely used when people had disposable income, but with a cost of living squeeze like we’ve never seen before, they are being dropped. We have no consumer discretionary businesses at all.”

Wright, who also manages the open-ended Fidelity Special Situations, takes a somewhat different view. His contrarian approach involves finding unloved companies entering a period of positive change before the wider market recognises what’s going on.

“We are guided by valuations, so we look to add to existing positions or start new ones where we feel they are pricing in a very pessimistic outlook, but where we have confidence that they can positively change over the medium and long term,” Wright explains.

Cyclical stocks on the discount aisle  

Market turbulence therefore offers great opportunities. Late February’s volatility, as Russia launched its invasion of Ukraine, provided opportunities to add to defensive holdings that had sold off heavily even though they were little impacted by the war, including Serco (LSE:SRP) and Imperial Brands (LSE:IMB). Wright also increased his exposure to high-conviction holdings such as Ryanair (EURONEXT:RYA) and consumer finance firm Kaspi (LSE:KSPI)

He observes that this year’s sell-offs in the UK have been “sharp and indiscriminate”, and that although near-term economic prospects are now pretty gloomy in the face of inflation and the risk of recession, markets are already pricing in a downturn.

“We believe sentiment has recently become overly pessimistic,” he says. “Cyclicals and mid/small-caps, for example, have significantly derated, reflecting excessively negative outlooks – and that is starting to present us with attractive opportunities.”

Like Lance, Wright has recently been looking closely at consumer discretionary stocks as values have dropped. He has also been taking profits from life insurers and using them to add to banks such as Barclays (LSE:BARC). He argues that banks will benefit not only from rising interest rates, but also “from expanding loan books at a time when most consumers and large corporates have ample ability to borrow and may need to do so to meet rising costs”.

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