As the bull market charges on, Jim Henderson and Nick Purves argue that opportunities to find value in equities still exist.
Value investing is an investment strategy that seeks to identify stocks trading at a discount to the assets or cash flow they represent. However, as global stock valuations continue to climb, are the opportunities for value investors becoming too hard to find?
“While valuations across global markets appear stretched, it is important to recognise that for every dollar invested in the S&P 500, 80% of that is being invested in the top 50 companies,” says Jim Henderson of Aristotle Capital Management. “Therefore, there are 450 companies not receiving the same level of inflows and this will skew any valuation data.”
That disproportionate investor focus on the top 50 companies means that the remaining 450 in the index are under-researched securities, potentially presenting value investors with unrealised opportunities at more attractive valuations.
One of the key variables investors use to determine valuation is the price/earnings (P/E) ratio. This is the ratio of a company’s share price to its earnings over the past 12 months. The ratio can also be calculated for the market as a whole, and is a widely recognised measure of the value of equities. In simple terms, a lower ratio indicates better value.
Global market indices, including the S&P 500 and the FTSE 100, have recently been showing P/E ratios significantly above their respective long-term averages. The P/E ratio for the FTSE 100, for example, has been hovering around 30 points since late last year, even though its long-term middle range is 15–17.1
“Under expensive market conditions, there will always be companies experiencing setbacks and it’s up to us to identify when those are temporary setbacks,” says Nick Purves of RWC Partners.
“For example, Rolls-Royce has been managed poorly in the past and has issued a number of profit warnings. However, we believe that the company is fundamentally strong and should be capable of delivering at least the [same level of] double-digit margins that it has in the past,” he says.
First known for its luxury cars, for which it was established in 1904, Rolls-Royce is now the world’s second largest manufacturer of aircraft engines and its 16th largest defence contractor.2 The company boasts an aura of exclusivity, yet it has not been immune from more run-of-the-mill problems.
“In January, the company had agreed to pay £670 million to the US and UK authorities as a penalty for using illegal middlemen and paying bribes to win overseas contracts,” says Purves. “This happened over a long period before the new management arrived. That fine will have to be settled, but in our view won’t affect the ongoing value of the shares,” says Nick.
Earlier this month, the Financial Reporting Council, the UK regulator for corporate governance and reporting, said it was investigating KPMG’s conduct in relation to its audit of Rolls-Royce’s financial statements.
However, Nick and his team haven’t felt the need to sell the position. They believe that the new management is taking the right measures to put the business back on the right course. Purves expects strong earnings growth to follow in time, a view not yet reflected in the share price.
Aristotle Capital Management and RWC Partners are fund managers for St. James’s Place.
The opinions expressed are those of Jim Henderson of Aristotle Capital Management and Nick Purves of RWC Partners and are subject to change at any time due to changes in market or economic conditions. This material is not intended to be relied upon as a forecast, research, or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any strategy. The views are not necessarily shared by other investment managers or by St. James’s Place Wealth Management.
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1 Source: Bloomberg, accessed 16 May 2017
2 Source: "Defense News Top 100 for 2013". Defense News. Retrieved 15 February