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On face value, the terms ‘Value’ and ‘Valuation’ appear interchangeable. If a fund manager says they follow either one of these investment approaches, surely this means the same general approach to investing? Not entirely. The differences can be material, and result in very different investment outcomes for clients.
Table 1 below illustrates the difference, at face value, between a number of managers who all use the term ‘value’ when explaining what it is they do:
|Fund||What the manager says||What the manager does|
|Coronation Equity||“valuation”; “long term”||Builds a diversified portfolio of shares which appear cheaper than what they are worth.|
|Investec Value||‘favourable valuations’; ‘abandoned shares’; ‘Non-consensus’; ‘Out of favour’||Builds a concentrated portfolio of shares which are unloved by the market|
|RECM Equity||‘price is what you pay, value is what you get’; ‘pay less than intrinsic value’, ‘long term’||Builds a concentrated portfolio of shares which are unloved by the market|
If you were to read the full description of these (and a fair number of other) investment approaches, it gets increasingly difficult to tell the difference. What seems to be coming through consistently is that professional fund managers research a range of shares and buy the shares they see as ‘cheap’ relative to its intrinsic value.
The chart below illustrates that these similarities are only skin deep. Over the past 10 years the funds highlighted in the table above have performed with wide ranging results:
Of particular interest is the past 3 years, where Investec Value and RECM (let’s call them the “Deep Value” funds) have substantially underperformed Coronation – all managers built around a ‘valuation definition’.
The consequence is that clients are now questioning the quality of certain of these funds and their managers when returns have been poor, and seemingly similar funds have delivered better returns. The reality is that the funds are managed very differently.
We hope to provide some insight in the points below to help clients understand and make decisions around which portfolios they use, and for what purpose.
Point 1: Diversification means different thing to different people
For a manager who is not too extreme in their investment views, decisions can be made at the margin. Often this is termed relative value, but what it means in practice is that the portfolio manager is well aware of the fact that they could be wrong in their views, or alternatively (and more common) the market may not reflect their views for some time. Managers who think like this tend to diversify more than those who do not. They are hedging themselves against the fact they may be wrong. What you end up with as a client is a portfolio which has numerous sources of return, and tends to perform roughly in line with the average of all shares in the market as a consequence of broad diversification – out- and under-performance relative to the All Share will be less severe compared to the Deep Value managers. Coronation is in this camp.
Fund managers who have a strict sense of the term ‘value’ will behave very differently. They are beholden to the opportunities thrown up by the market (the unloved shares), and their strict definition of value means their investment opportunities are all the more limited. In a broad investment market like the US or the UK a fund like this can still achieve diversification, however in a narrow market like SA, these funds often find themselves picking shares from a very narrow sector of the market. This approach creates an undiversified outcome, and a substantially bigger difference in return profile to the average share in the market. RECM and Investec Value are in this camp.
This is where we find ourselves today: Funds like RECM and Investec Value have found themselves with few real value opportunities in the market (we have had a protracted bull run in most sectors of the equity market), hence their portfolios being concentrated in very specific sectors – notably Platinum and Gold. This has created significant fund volatility, and they have underperformed as these sectors have continued to decline.
Point 2: Risk means different things to different people
There are two types of risk in the investment world: performance risk (the risk of underperforming the market or peers); and capital risk (the risk of losing client capital permanently). Deep value funds define themselves in the latter sense, where they will hope to invest in shares which have limited (permanent) downside potential. Coronation – while saying similar things – will tend to hold shares which are not necessarily that cheap – for performance risk reasons. What this means for clients is that there is a trade off when the difference between performance risk and capital risk is big – this is where we find ourselves today. Deep Value funds see large amounts of market risk and so focus portfolios in the real cheap opportunities so that they limit capital risk.
What can we then expect as investors in these funds?
Deep Value funds give you the bumpy ride, with the tradeoff that long term returns should come at a premium due to the concentration of holdings in the very cheap shares. This cheapness unlocks over time. These funds tend to fill the role of ‘performance enhancer’ within an equity portfolio. A longer term investment horizon is often required.
Relative value type funds give you returns in line with the broad market index. So while the performance risk is lower than deep value, the capital risk may not be. These funds tend to fill the role of the ‘core’ of an equity portfolio.
Each of these approaches to investing has their own merits. Deep Value is substantially more difficult for clients as it’s psychologically tough to remain invested in a fund which, by design, offers a very bumpy ride. In fact it’s been proven that the clients of these funds substantially underperform the fund itself, as they make incorrect allocation decisions such as selling when the fund underperforms. For these reasons, when constructing portfolios for clients, it is very important to accommodate the trade off between the clients’ own risk appetite, and the relative market and capital risks. What we tend to find is that by combining the two value approaches (amongst others), clients can achieve a higher total return, but with a balanced risk approach.