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The Long View: There is still worth in value

By Philip Coggan

Published: January 25 2002 17:32 | Last Updated: January 25 2002 18:01




It may be time to dust off that list of high-yielding stocks


Sophisticated investors sneer at the division of their profession into "value" and "growth" schools, seeing it as the kind of simplistic generalisation beloved of lazy journalists.


But last year, one of the simplest valuation measures available - dividend yield - was the key to successful UK investment performance. Value stocks, as represented by the highest yielders in the FTSE 350, outperformed the low-yielding growth stocks by 23 percentage points. According to the statisticians at CAPS, that followed a 30-point outperformance by value in 2000.


Value investors who fished among the market's minnows would have done even better. The highest-yielders among the Hoare Govett Smaller Companies index outperformed the lowest-yielders by an astonishing 59 percentage points.If only all simplistic generalisations were so profitable.


After all the fuss about "sophisticated" market measures such as EV/Ebitda (enterprise value/earnings before interest, tax, depreciation and amortisation), it may seem odd that something as rough and ready as the dividend yield could have been so useful.


But that may simply reflect the extremes to which the market's obsession with growth had driven valuations in the late 1990s. At the peak, according to Credit Suisse First Boston, the price-earnings ratios of the most highly rated stocks were 6.5 times those of the lowest-rated. That compares with a ratio of less than 3 for much of the 1990s.


All that we have seen, therefore, is a correction of the insane valuations witnessed during the technology bubble.


But the odd thing is that growth investors do not seem in the least bit abashed by their battering over the past two years. As soon as the market began to bounce in late September, they piled into the TMT (technology, media and telecommunications) stocks all over again. Because earnings have fallen as fast as share prices over the past two years, valuations in the technology sector are still up in the stratosphere. According to Thomson Financial, the historic price-earnings ratio on the sector is about 100.


So why are investors, having been once bitten by the technology bug, not twice shy? One answer, according to Bart Dowling, director of global asset allocation at Merrill Lynch, is that investors are not entirely rational.


His statistical analysis shows that investors are much more influenced by recent returns than they are by long-run performance. In the late 1990s, the returns from owning technology stocks were phenomenal. Any fund manager who was underweight in the sector underperformed the indices and was in danger of losing clients.


This episode is still scorched into investors' memories. At the hint of a revival in technology stocks, therefore, managers decide they cannot afford to be underweight. This is the "lottery ticket" approach. It is not rational to buy a ticket (since the expected return is negative) but gamblers ignore reason for the chance of a big pay- out.


The passion for growth stocks may be reinforced by the feeling that overall returns from equities are likely to be low in future years. An annual return of 7 per cent or so simply looks unappetising to most investors. Growth stocks offer stronger meat.


Value stocks, in contrast, are seen as working just once in the cycle (as an economy emerges from recession) but are not serious long-term investments.


Academic evidence, however, suggests that, over the long term, value strategies such as buying companies with low price-to-book ratios tend to outperform the market. Remarkably few fund managers have attempted to exploit such apparent anomalies.


This may simply be a function of the lack of respect with which the fund management community holds academics. They did not believe the academics when they said the markets were efficient and that most active fund management is a waste of time; they do not believe them now when they are told to concentrate on value stocks.


Psychologically, too, it may be difficult for fund managers to hold value stocks, which tend to be concentrated in unfashionable businesses. Owning, say, a portfolio of construction companies may be a hard sell to clients. As Phillips & Drew of the UK has discovered, fund managers face the business risk that clients may desert them before the cycle turns in their favour.


A more fundamental problem is that it is extremely difficult to exploit value effects, like the low price-to-book anomaly. The kind of companies that tend to meet value criteria are often very small, and fund managers cannot get the desired liquidity. Similarly, private investors cannot assemble a sufficiently large portfolio to diversify away from the specific risk of owning such companies.


So the chances are that value investing will remain a minority sport, despite the fantastic performance figures of the past two years. We will eventually see a repeat of the recent cycle, with investors pursuing growth until valuations become excessive and value kicks in again.


Where are we now in the cycle? It is tempting to think, after two fantastic years for value, that it is time to switch back into growth. But bubble valuations have not entirely disappeared, even if one dismisses the price/earnings ratio of the technology sector as a statistical fluke (on the grounds that the sector has virtually no earnings). Other measures such as price-to-sales still leave the market looking more expensive than it was in the early 1990s.


That suggests one more year of modest outperformance from value stocks before the growth cycle kicks in again. Time to dust off that list of high-yielding stocks.