Where value investors are now hunting for opportunities

As we covered last September, value-focused funds and investment trusts have been on a tear, with various examples of significant gains made over three and five years.

Higher interest rates, which look set to remain at current levels for the foreseeable future following the rise in geopolitical tensions in the Middle East, are a tailwind for this investment style. 

• Our Services: SIPP Account | Stocks & Shares ISA | See all Investment Accounts

Value or contrarian fund managers search for stocks that appear to be trading at prices lower than their true value, taking into account how much money they make and how much excess cash is being generated. Such out-of-favour companies tend to have a low price/earnings (PE) ratio, which compares a company’s value with its profits. If the company pays dividends, it will likely have a high dividend yield.

Such companies tend to be found in sectors that are more economically sensitive, including finance, energy and materials. Value stocks are cheaper than growth stocks, with valuations more reflective of current earnings as opposed to future potential.

Fund managers who hunt for value shares don’t simply buy on valuation grounds alone. They also look for, and hope for, a catalyst to revive an under-priced company’s financial fortunes. This could be a restructuring, refinancing, or management change.

A key trend

Following a run of strong performance, value-focused fund managers have been making tactical adjustments to ensure that their portfolio of companies still represents good value. A key trend at the moment is increased exposure to stocks that are typically considered to be “quality growth companies”. Such firms have appeared on the radar of value fund managers having underperformed the market in recent years.

Speaking to interactive investor in March, Artemis Global Income fund manager Jacob de Tusch-Lec, noted that on the back of strong gains for the fund over the past five years “it is clear that when we look at our portfolio now, a lot of our names are not on the naughty step anymore, and that is something we’re cognisant about”.

At the time of the video interview, de Tusch-Lec noted that some quality growth stocks had “started to look interesting again”, but his focus was on adding to pharmaceuticals, naming AbbVie Inc, Pfizer Inc and Bristol-Myers Squibb Co.

He said that the portfolio is trading at a 40%-50% discount to the global stock market, pointing out that despite having some huge winners, such as top holding Samsung Electronics Co Ltd DR, “a lot of our stocks have not re-rated as quickly as the rest of the market”.

• Artemis Global Income interview: top stock performers and where fund is now looking for value
• Artemis Global Income interview: buying some portfolio insurance and bucking trend on US and AI

A disciplined approach

The global income investor, who has managed the fund since it launched in 2010, said looking for new opportunities helps keep him disciplined. 

De Tusch-Lec added: “A lot of quality growth stocks that are classic holdings in a global income portfolio and have done really badly over the last five years, we’ve done well not being in them. Food and beverage stocks, the Unilevers of the world, the Diageos of the world. There’s a reason why we weren’t invested in them, and we’re still underweight the space.

“But I would say that going forward, some of them are starting to look interesting again. As a fund manager, you have to always look at the portfolio and be very humble and say, what could go wrong? And constantly rotate rather than just say, ‘this is my portfolio I stick with it, these are the best companies in the world’.

“So, over the last three, four, five months, we have, for example, added a bit more to pharmaceuticals, which have become quite cheap, and taken down some of our banks and defence exposure. Fundamentally, the portfolio is still the same. We’re overweight financials, we’re underweight tech, we’re underweight the US, and overweight emerging markets. Those are the key building blocks, but the level to which we’ve taken some of these overweights and underweights has gone down.”

High quality at a cheap price

Ben Whitmore and Kevin Murphy, fund managers of TM Brickwood UK Value, note the trend of “high-quality businesses trading at discounts not seen for many years”.

The duo say that five years ago the standout sectors for value investors were banking, energy, telecommunications, tobacco and mining.

However, this has now changed, with the pair saying: “Today, these have been replaced by a group of businesses that might be described as ‘faded glamour’ stocks - companies with strong brands, durable cash flows and global franchises whose valuations became stretched during the low interest rate era and have since normalised.”

According to them, examples of companies that fit into this category include Diageo, Bunzl, Tate & Lyle and Reckitt Benckiser Group.

Whitmore and Murphy add: “Alongside these [four companies] sit former growth stocks where expectations proved overly optimistic and share prices subsequently adjusted, including UK housebuilders, JD Sports Fashion, B&M European Value Retail, Burberry Group and Prudential.

“The passage of time means that areas that were once too expensive for us to consider are now lowly valued, and vice versa.”

Simon Gergel, manager of The Merchants Trust (LSE:MRCH), has also been tapping into this trend through Premier Inn owner Whitbread, Hikma Pharmaceuticals and Reckitt Benckiser.

In a recent video interview with interactive investor, Gergel said: “We’re looking to take advantage of some of those companies where we’re confident that the business is fundamentally sound and valuations are attractive.”

• The Merchants Trust interview: high-yielding shares and looking outside FTSE 100 for income
• The Merchants Trust interview: how this dividend hero delivers a market-beating yield

Nick Purves, manager of investment trust Temple Bar (LSE:TMPL), has also been eyeing opportunities among businesses usually considered quality growth companies. 

In an update to investors at the end of January, new positions included consumer goods giants Diageo and Smith & Nephew, the medical device maker.

Speaking at an investment event in March, Purves said: “Consumer staples have had a difficult time over the past couple of years. One reason is down to becoming too expensive and too highly priced. For example, Diageo got to around 25 times earnings in 2022.

“Another reason is that consumers have become pickier and more price sensitive. Therefore, price increases are not as easy to come by as in the past.”

Regarding Diageo, Purves said that following a sizeable share price fall in recent years (down just over 50% in five years) the firm is now carrying a much lower valuation (citing a price-to-earnings ratio of 12x).

He noted: “For lowly valued companies the scope for surprise is much greater. For Diageo, we feel positive the shares can deliver an excess return from here. There’s a new CEO in Dave Lewis, who turned around Tesco, and he has come into Diageo to simplify the business and turn it around.”

• Eight hidden gem funds investors are missing out on
• Sign up to our free newsletter for investment ideas, latest news and award-winning analysis

Describing his value investing process, Purves said: “We are looking for companies that are sleeping giants – those that have lost their way – which has led valuations to come down to low levels.”

As Whitmore and Murphy both note, an important thing to remember, particularly when stock markets become more volatile, is that “over the longer term, starting valuations are the most reliable guide to future return”.