In this article from The IRS Report published in October 2009, Peter Shearlock explains why value investing still makes sense...

Why value investing still makes sense - and four stocks that look good now

There is a mountain of evidence to show that a value-based approach to investing – picking shares that are valued in the market at less than their true worth – pays off over time. But there are periods when value investing does less well than momentum investing. The past 18 months are a case in point.

For much of 2008, the market was obsessed with actual or expected dividend cuts. Since value stocks are often high yielders, that depressed performance. Even so, over the five years to end-2008, value stocks – as measured by the FT 350 Index of higher yielding shares, still outperformed momentum stocks – as measured by the FT 350 Index of lower yielding shares, by 2.8%.

So far this year, value stocks have again taken a back seat as investors have piled in to recovery stocks – the so-called “dash for trash”. In the past three months, for instance, momentum shares have returned over 20% while value shares have returned under 16%.

But this is a not a time to lose faith in the value philosophy – see panel overleaf. And after the  recent run in momentum stocks, value stocks have some catching up to do. They often underperform at the start of a bull market when people are chasing recovery stories. But, given the prospect of a low-growth, low inflation era ahead of us, value stocks – inherently more defensive than momentum stocks – should prosper.

So where is value to be found now? I have gone back over my past selections here and picked out four shares I believe continue to show excellent value.

The first is Cable & Wireless. Shares in the telecoms group sailed through last year’s bear market but have lagged this year’s rally. They now sell for barely ten times anticipated earnings for 2009-10 and offer a yield of 5.8%. This is despite continuing growth in the international businesses and a move into positive cash in the corporate services business, now called “Worldwide”. C&W has little debt.

The key to the share price lies in the long-mooted plan to split the business in two with separate listings, gear up debt levels and use the money to buy back shares. One or other of those businesses would then look a likely takeover target. Analysts reckon there is at least another £1 of value to be had with this approach.

De La Rue shares have also gone sideways for much of the past two years. The banknote and identity systems maker recently won a ten-year contract to produce the UK’s new biometric passports and has extended its exclusive deal to print the UK’s paper currency. The company throws off cash at a prodigious rate and is not shy of handing it back to shareholders from time to time.

De La Rue lifted earnings by 37% last year and the shares would be higher were it not for problems in the cash processing side. But this is small in relation to the rest of the business. De La Rue is one of Britain’s best companies, with good management, little debt and good forward earnings visibility. The shares deserve a premium rating.

CDs and books retailer HMV has been transformed since Simon Fox took over as chief executive two years ago. He is battling the decline in the company’s markets with new store formats, a move into preplayed games and the wider entertainment market, and a central book hub for Waterstone’s. The strategy is paying dividends in the UK but the company’s Canadian operation is still losing sales and is a drag on group profits.

However, this is all allowed for in the current price. After a recent sell-off, HMV is selling for about eight times anticipated 2009-10 earnings and offers a high and sustainable yield. Broker Nomura has a 165p share price target on the shares.

Legal & General shares have come up by a half in the past three months but still look undervalued. The life assurer has big holdings of corporate bonds which have rallied well of late. It also has a big exposure to UK commercial property where prices are probably now bottoming out.

The recent half-year figures were all but impenetrable with profits almost obliterated on one accounting measure but up 12% at £657m on another. The key for me was a rise in the net cash flow to £302m, which compared with £320m for the whole of last year. L&G is writing new business on a very selective basis and being tougher on claims. After rebasing the dividend, the current pay-out looks positive.

The big challenge facing L&G is a new Europe-wide solvency regime due to be implemented in 2012 and which would hit annuity providers, such as L&G, especially hard. Together with other annuity providers, L&G is lobbying hard to push through changes. We will know by the end of this month whether the regulators have been listening. If they have, L&G’s shares will respond positively.

You can see all of Peter Shearlock's articles at www.TheIRSReport.com

Peter Shearlock writes in The IRS Report regularly

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