River and Mercantile’s Dan Hanbury has introduced a bias towards value stocks in his £244.7m R&M UK Equity Income fund in the belief that the market is on the brink of seeing a major reversal in which investment style pays off.
Numerous academic studies have shown that value investing tends to outperform quality stocks over the long run but in the years since the global financial crisis this has been far from apparent.
As the graph below shows, for example, the MSCI World Quality index has returned almost 42 percentage points more than the MSCI World Value over the six years were markets have been on a generally upward trajectory.
Performance of indices over 6yrs
Source: FE Analytics
One reason for the outperformance of quality over growth was the policy response of the world’s central banks to the global financial crisis. The extra liquidity created by historically low interest rates and unprecedented quantitative easing programmes drove down bond yields and pushed investors into the dividend-paying equities.
However, River and Mercantile Asset Management head of UK equities Hanbury believes the market is approaching an “inflection point” for bond yields, which would mean that the dominance of quality over value could be set to end.
Part of the FE Alpha Manager’s process looks at how various ‘factors’ – such as value, quality and momentum stocks – are performing. While quality and momentum have outperformed value over recent years – and indeed continue to do so in the current market – he says the “extreme” level of this outperformance suggests a reversal is on the cards.
“You’ve had a phenomenal re-rating of high quality stock on a price-to-book basis and it’s been an amazing trend to play. I’ve benefitted from the high quality trend as much as the next person but when we look at some of the other indicators, we think we’re getting pretty close to the end of that trend and think it’d be dangerous to stick with it,” he said.
“When we look at our factor data over the last 100 years, where we are at the moment – with 200-year highs in bond markets and all the rest of it – the next big trade has surely got to be the value trade. That’s where you’re going to make money on a 10-year view and I don’t want to miss that by being on the wrong side of it when it happens.”
“One of the reasons we’ve been positioning more into value is that we’ve started to see extremes in momentum outperforming. When we’ve seen that historically in previous cycles, it’s often been followed by a big reversal. You sometimes get changes in correlations in the market and maybe momentum starts to do less well.”
Style Research shows that R&M UK Equity Income has 39 per cent of its portfolio in large-cap value stocks. 19 per cent in mid-cap value and 18 per cent in small-cap value; all these allocations are overweights relative to both the average IA UK Equity Income portfolio and its FTSE All Share benchmark.
The manager has not expunged his portfolio of quality stocks, but more recent additions have a definite value flavour to them.
One of these is multinational banking and financial services company Standard Chartered, which has seen a significant share price fall over recent years.
Performance of stocks vs index over 3yrs
Source: FE Analytics
“We don’t often have banks in income portfolios, particularly ones that have cut their dividend, may have a rights issue and rely on emerging markets. Why have we bought Standard Chartered?” Hanbury said.
“Having become more favourable towards banks overall – we’ve already added Lloyds and HSBC – it was inevitable that Standard Chartered could start to score more highly on our screens and it came up on our asset-backed and recovery screens.”
“After some work on it, our view is that what is being priced in is an outlook as bad as the Asian financial crisis in 1998. The valuation is even looking slightly cheaper. We’ve taken the view that we can buy into that low valuation – even if we haven’t timed it right and there might be some more downside – as we think we’re almost at the bottom.”
Of course, the big risk for the manager’s strategy is that quality continues to outperform: “We are betting on this big trade into quality stocks running out of steam. At the moment, that’s coming back to bite me because they just continue to do well.”
Over 2015 so far, the MSCI World Value index has posted a loss of more than 0.5 per cent while the MSCI World Quality is up 6.42 per cent as central banks pushed back the outlook for likely interest rate hikes and more turbulent market conditions pushed investors in areas of perceived relative safety.
Performance of indices over 2015
Source: FE Analytics
“OK, I’m missing out on some of the latent momentum in some of these quality stocks now and the quality guys are still having a great time milking it. But I’d rather miss a bit of the end of that and suffer for a few months to make sure I’m on the back of the next big trade,” Hanbury said.
“The big fear for me with a value tilt in the portfolio is that those bond yields collapse again for whatever reason and stocks like SAB Miller start to trade on 35 times. That’s unprecedented but could happen.”
Tom Jemmett, fund analyst at Brewin Dolphin, said: “Traditional value strategies in the UK market have, on the whole, suffered on a relative basis post-financial crisis. Although the academic research would suggest these dedicated value approaches will once again have their day in the sun, finding fund managers adopting a pragmatic approach to style has been rewarding, especially given the pockets of outperformance we’ve seen for value characteristics.
“Dan Hanbury and the River & Mercantile process lends itself to finding these pockets of strength, be it value or growth, and we think this approach stands the portfolio in good stead to weather these style trends.”
The manager has run the four FE Crown-rated fund since 1 August 2013, over which time it has posted a 12.81 per cent total return. This is slight underperformance against its average peer in the IA UK Equity Income sector but higher than the 6.23 per cent made by the FTSE All Share over this time.
R&M UK Equity Income has a clean ongoing charges figure of 0.94 per cent and yields 4.03 per cent.
