Joel Greenblatt, the prominent US fund manager, once wrote that “buying cheap stocks at bargain prices is the secret to making lots of money”. Part of the challenge however, as Greenblatt noted, is that value investing doesn’t work all the time. Indeed, over the past two years, some of the value strategies tracked by Stockopedia have had a rough ride. But we’ve seen some changes in that trend in 2016, with Greenblatt’s Magic Formula strategy putting in a strong performance in the UK, Europe and the US.
To understand this performance, it’s worth exploring some of the factors that drive value strategies - and why hardened value hunters are prepared to ride out periods of underperformance in the expectation of stellar returns.
What really makes a value stock?
Value strategies come in a variety flavours, but they all share a focus on stocks that are priced cheaply against either what they earn or what they own.
Take for example, the classic value investing style of the late Ben Graham and modern day hedge fund guru, Seth Klarman. Their focus digs deep for stocks that trade at prices well below their intrinsic value. These are the companies hated most by the investing herd. They’re potentially broken or at the bottom of the business cycle, and very few can stomach buying them. But they are also the stocks that value investors believe are mispriced and will rebound in time.
A similar approach is used by Nick Kirrage, who runs the Schroder Recovery Fund. As he puts it: “Value outperforms over time, and when it doesn’t I think a lot of the skill in the job is psychological. It’s about learning not to drive yourself crazy or fall apart on bad performance. Over time you have a strategy that outperforms, but you also know that you’ll struggle with it.”
Another challenge of hunting down ‘absolute’ value is that the pool of potential targets dries up quickly in bullish conditions (when a rising tide floats the valuations of many stocks). At times like these, growth strategies often dominate, leaving value investors on the sidelines. Back in the late 1990s there was a value drought that lasted five years and cost the jobs of many value-oriented fund managers.
Despite these challenges, value strategies can still work well even in strong markets, and it’s here that the Greenblatt model has proved effective…
