Value investing should be about business resilience

Investing style is how investors typically make sense of their portfolios. Emphasis can be on big or small companies, and labelled as “growth” or “value”. Each person’s style preference will fit their longer term goals, or even just match their own personality or attitude to risk. Investors can gain from clear thinking about style. Unfortunately, labels like “value” and “growth” are often misunderstood.

Growth investments have been on a winning streak for several years, against a background of disinflation and low global growth. As economic cycles have flattened, and investors have put a premium on genuine underlying growth – boosting the ratings of businesses that can make steady progress. But, investors should give thought to how far this remarkable trend for growth stocks can run. It might be time for other styles to shine.

What are the alternatives? Value investments – businesses that are more cyclical, troubled or just look cheap – have been laggards in recent years. But is this what value investing should really mean? It may be that the underperforming businesses are cheap for a reason, and there is no economic recovery or inflation to bail them out. What looks like bargain investing, may be a risky approach unless inflation breaks out globally. Even the higher dividend yields that these companies typically offer can come under pressure, with dividend cuts as profits shrink.

For investors concerned that growth shares have had a good run, switching now into deeply discounted businesses may not be the answer. Valuation itself on stockmarket ratios looks like a flawed tool for value investing. It may be that the real alternative to growth is being contrarian. Value driven by a contrarian analysis can actually be a good guide to picking shares in a turbulent world.

A number of notably successful investors approach stockmarkets in a contrarian way. Warren Buffett is the best known example – not picking inherently bad businesses, but seeing potential that others might not fully recognise. These companies may not initially look cheap, and they may not even be particularly cyclical. Finding them takes deeper, more original, thought.

The first rule is to think about longer term risks to a business, rather than today’s valuation or growth estimates. For investors who – like Warren Buffett – rarely sell shares, the long term return to a shareholder will eventually be much like the underlying business performance. This points to favouring a good business, with opportunity to deploy the cash it generates. A contrarian approach can help with identifying good entry points to buy these types of shares.

Investors should recognise that the biggest danger is poor underlying long term returns in a business. This is often created by bad management or governance, or simply by being in an area that is likely to be disrupted by new entrants. Businesses that collapse typically show high levels of borrowing, poor governance, weak business models or questionable accounting. These can be value traps – few are good at pricing inherently risky businesses.

And, in many sectors, there is potential for new entrants to change economics. Think of what is happening on the high street as online sales erode the customer proposition of many. Or banking, where challenger banks are operating without the outdated systems and branches many legacy banks are burdened with. Even the collapse in oil prices has been driven by disruptive new technology in US shale drilling.

The challenge with a contrarian approach is that it requires a long term perspective. Investors need resilience; these investments can look silly for some time. It may also mean largely ignoring sectors such as banking that are ripe for disruption. But these problems may actually give for private investors an advantage. For big institutional investing firms – accountable for performance quarter-by-quarter – patience is in short supply. Explaining contrarian investments to their clients can be difficult.

Low global growth limits the opportunity for bad businesses, but equally growth businesses are currently extremely highly prized. But there are still companies that have genuine growth potential, but are simply misunderstood. Investors need not avoid growth stocks, but can bring a contrarian edge to sourcing opportunities and recognising disruption risk.

A version of this article was published online in Personal Finance in The Herald on 4 June 2016.

Disclosure: The opinions expressed in this article are my own, and may not represent the views of any firm or entity with which I am affiliated. The information presented in this article has been obtained from sources believed to be reliable, however, I make no representation as to their accuracy or completeness and accepts no liability for loss arising from the use of the material. Articles and information do not represent investment advice.

Image credit: Creative Commons Some rights reserved.

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