Classic value shares return 76%
Posted on November 26, 2009 by Richard Beddard
Filed Under Editor's choice, Investing |
27 shares trounce the index.
A year ago yesterday I included a list of classic value shares in an article, Back to Basics (see: pages 1,2 and 3 - all pdf) for the January 2009 edition of Money Observer magazine. This weekend I drafted an update, maybe they’ll call it Back to Basics 2. It will be in published in the January 2010 edition, although it goes on sale in December.
Last year’s list (click for a larger version) is up, 76% in one year including dividends, charges and tax. The same amount invested in a FTSE-All Share ETF would have returned less than half, about 35%. Remarkably, the price of only one of the 27 shares, St Ives, fell - by 11%. The rest returned between 5% (Kier) and 227% (Computacenter).
Now, it would be hypocritical of me to crow about a single year’s returns (though I’m not above sticking them in the headline), when I know full well that it’s the long-term that matters, but I think we can learn from the fact that these shares not only bettered the market’s rally since March 2008, they didn’t lose money in the first three months of 2009 when the market capitulated.
James Montier created the list for me. He borrowed a formula invented by Benjamin Graham just before he died in 1976. The formula relied on three criteria to pick undervalued companies:
- An earnings yield of more than twice the composite AAA corporate bond yield (then about 5 per cent)
- A dividend yield of at least 2/3 the AAA bond yield
- Total debt of less than 2/3 of tangible book value (the value of the physical assets of the company minus its liabilities).
Montier added a fourth criteria, a Graham & Dodd price earnings ratio of less than 16. The Graham & Dodd PE is the long-term PE. It compares the price to its average earnings over the past ten years.
The earnings yield is the company’s earnings per share (profit) divided by its share price. Since the profits belong to shareholders, the earnings yield is a measure of return - provided the company continues to be as profitable in future.
The dividend yield is a measure of that part of the company’s profits that are returned directly to shareholders rather retained by the company to finance future profits.
Both of these measures focus on reward, but Graham was also concerned to minimise the risk that the promised reward might not materialise. That’s why he insisted on a relatively low level of debt, his studies having shown debt was the most significant financial risk for a company.
Montier added the long-term PE to counter another kind of risk, that the company might look cheap because of its high earnings yield, but only because it had just experienced an unusually good year, which might not be repeated.
This is why I think the classic value shares did so well: The low-risk factors (long-term PE, and ratio of debt to tangible book value) meant the shares did relatively well in the period of extreme uncertainty at the beginning of the year, and the high return factors (earnings and dividend yield) appealed to investors on the bounce-back.
Exactly as described in this model from Morgan Stanley.
Classic value shares won’t do well in runaway bull markets. Then, they will almost certainly lose out to growth shares. But in the long-term Graham, Montier, Morgan Stanley, and I all agree: In the financial game of paper, stone, and scissors, value beats growth, but value combined with low-risk factors beats both.
Graham, who preferred to sell when a share rose 50%, would almost certainly have sold the winners in this list and invested them in cheaper shares that met his criteria.
If he were to do that now, which shares would he chose?
Using data available to private investors at modest cost, I can’t replicate Montier’s table but I can get pretty close.
Using long-term gilt yields of about 4%, instead of AAA corporate bond yields, means only shares with an earnings yield above 8% and a dividend yield above 2.7% will qualify. An earnings yield of 8% is the same as a PE ratio of 12.5.
Plugging those values, and Graham and Montier’s risk factors into the Sharelockholmes database gives the following result:
Incredibly Computacenter, last year’s biggest winner, still makes the list. There are 37 main market companies and although we didn’t include them in the original list, I’ve added the 18 AIM companies that meet the criteria. Half of the AIM companies have market capitalisations under £10m. I’d be especially wary of those.
At the other end of the scale, there are three FTSE 100 companies including BP and Shell, and household names like Bloomsbury and Aga.
I think there are plenty of bargains in this list, but I always verify the data from a company’s annual reports before I invest in a share or profile the company on this blog.
And please remember, profits from investing in classic value shares will be far more modest in most years, and they be negative in some.
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A ‘mental’ recovery
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The US shouldn’t be worrying about its growing deficit, says Paul Krugman, “a decade from now interest payments will reach a level not seen since… 1992,” and the market isn’t worried either.
Graeme Pietersz thinks he knows how to fix capitalism, and bloggers are nailing up his manifesto.
Don’t believe the buy recommendations, says Jeff Matthews, the latest analyst to be hounded out of a job for writing a sell recommendation is Brian Kennedy.
Comments
7 Responses to “Classic value shares return 76%”
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Well done, good result. But I’m interested in the oft heard comment about the long term being what matters. I fundamentally challenge this as the long-term is an aggregate of a lot of short-terms. In the article here you say now would be the time to re-evaluate against the selection criteria and make some switches. That is exactly what supports my view that the long-term isn’t what it’s about at all - i think it’s about knowing what cycles you are trading in, and knowing when to move on.
Thanks Douglas. You make a very interesting point. I think the long-term matters for the strategy, not these particular stock picks. So I’d be switching like for like, buying new value when the old value shares have gone up in price. The temptation, if I felt the market was ‘exuberent’ would be to make a different kind of switch - into growth and momentum shares. I wouldn’t be inclined to do that because because I have no confidence in such shares. They have an awful tendency to follow each other lemming-like over the cliff when the bull-market ends. So my strategy would be to stick with value through thick and thin, accepting periods of poor performance in the knowledge that in the long-term value wins.
My question for you is, what do you mean about knowing when it’s time to move on?
Do you mean knowing when a share is no longer cheap, and moving on to another, cheaper share?
Or do you mean knowing when cheap shares will no longer generate the best returns, and moving on to more speculative shares?
[...] Classic value shares deliver 76% – iii blog [...]
Well done Richard and well done more broadly on a jolly good blog.
Thanks Theo, much appreciated.
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