This article from Chris Gilchrist was originally published in The IRS Report in February 2011

Why value strategies need active management

According to the super-bearish Societe Generale strategist Albert Edwards, the US stockmarket is now significantly overvalued. Its cyclically adjusted price earnings ratio (CAPE) is about 40% above its long-term average. On this basis the SG team argues that returns from US equities for the next decade will be low. On the other hand, many US value managers claim that many US large-cap stocks are cheap. The same discrepancy exists in other markets, though in less extreme form, including the UK, where the mega cap oil and pharma stocks are certainly not expensive in historic terms.

There are some special factors that may be exaggerating the degree of average CAPE overvaluation. In the US, the huge rise in the capitalisation and valuations of Apple, Google, Amazon and the like have led to a "bar-bell" market reminiscent of the "nifty fifty" of the 1960s. The chosen few trade on stratospheric ratings while what are seen as dull plodding stocks remain cheaply valued. This was also the story in Japan just before its crash in 1990, and as the Soc Gen team never tire of pointing out, Japanese value stocks then outperformed both growth stocks and the market average for a whole decade. Long-term studies of the developed stockmarkets strongly suggest that if you can find established, soundly financed businesses with strong business models on dividend yields of over 5%, where there is a realistic prospect of dividends rising in line with inflation or better, then you should buy them. Like everything else, these stocks will lose you money in a crash but over most decades they will make you a lot of money.

This rationale of value investing underpins both Peter Shearlock's value selections and Douglas Moffitt's Rising Income Retirement Portfolio. Some have argued that if you stick to mega cap stocks, holding ten stocks is enough to diversify: but recent experience with the banks and BP suggests that a portfolio of 20 stocks is required to reduce risk to comfortable levels. If you do not have enough capital to create a 20-stock portfolio, then value-based funds are a worthwhile alternative.

A big issue is that managers' charges - typically 1.25% to 1.5% a year - will subsctantially reduce the net yield. This may not matter so much if you are buying these funds for expected capital returns, but it will much reduce their attractions as income generators. The panel lists a fewof the better candidates among both open and closed-ended funds. A newer alternative is funds using quantitative methods to select value and yield stocks. I-shares has the FTSE UK Dividend Plus (IUKD) while Vanguard runs a FTSE UK Equity Income Index fund (an OEIC), which tracks an index created to its specifications by FTSE.

A comparison of the two indices is interesting. I-shares weights stocks in its index by yield, so the higher the yield, the higher the weighting. This did not help its performance in the crash because it resulted in heavy weights in the banks. Vanguard's method selects the high yielders but then gives them weightings in its funds based on their market capitalisation. Both indices use prospective yield based on company announcements - in other words, companies that announce dividend cuts are removed. The history is too short to draw firm conclusions for these two funds, but the I-shares fund underperformed the FTSE100 massively in the crash, and both funds have only matched the Footise since then. Notably, respected managers of income funds such as Invesco Perpetual's Neil Woodford have also struggled to beat the market during the past two years. When value is out of fashion (as it was in 1998-2000), the strategy treads water - it is only guaranteed to bring home the bacon over longer periods.

A number of studies have shown that high-yielding value stocks (high-yielders with good finances) outperform market averages substantially, and SG shows that the method works in emerging markets too. But in the high-yield world, it is not always easy to identify the turkeys in advance, which is why I suggest that it is worth incurring the management fees of actively managed funds rather than trusting the quants.

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Chris is the editor of The IRS Report every month

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