Why a value approach to investing is key to The Merchants Trust’s success
Growth versus value is a hotly debated subject. The former generally outperformed in the decade-long low interest rate environment, but the latter has now received a welcome boost. Merchants takes a value approach to investing, and managed to deliver strong performance, over time, even when value was out of favour. That’s because the managers are experts when it comes to identifying good, fundamentally sound businesses.
3 key take-aways
- The Merchants trust takes a value approach to investing, which is based on the fundamental belief that the true value of a stock can be determined by research.
- This approach has been out of favour for the past decade or so, as growth stocks reaped the benefits of the low interest rate environment.
- But today’s higher interest rates can provide a tailwind for Merchants, as investors favour nearer-term tangible cash flows over future potential cash flows from higher growth companies.
Value-approach managers have often been frowned upon over the past several years, with value stocks left languishing by many. However, the higher interest rate environment did give a welcome boost to companies with visible near-term cash flows and solid business models, otherwise known as value stocks, with the value-focused Merchants Investment Trust a beneficiary. Unfortunately this was not a wholesale change and headwinds have remained, though where there is pain for the value investor, there is often also opportunity.
What is value investing?
The economist, Benjamin Graham, is the ‘father’ of value investing. He developed his theories on the subject in the 1920s at Colombia Business School before publishing them in his book, Security Analysis, in 1934. Graham’s original conception of value investing was based on the fundamental belief that the true value of a stock could be determined by research. That belief remains at the core of the value approach today.
Contemporary value investors seek to identify companies which have strong fundamentals (which include factors such as a company’s profitability, revenue, liabilities, and growth potential) but are undervalued by the market and considered to be trading below their intrinsic value. These investors tend to move away from the broad market consensus to look for opportunities that others miss, where businesses with attractive fundamentals have diverged from their share prices. In other words, their fundamentals look good, but their share price isn’t reflecting that. One of the most famous advocates of value investing, Warren Buffett, famously described the approach as “Price is what you pay, value is what you get.”
Value versus growth
Some readers may be familiar with value’s alternative: the ‘growth’ approach to investing. Growth investors look for companies which have the potential to grow their earnings rapidly and see their share price increase faster than the average. These investors generally pay a higher price for these companies.
The low interest rate environment we’ve seen over the past decade or so has made growth a popular choice. But that all changed towards the end of 2021, when we began to rotate to a higher inflation and rising interest rate environment, which had an immediate mathematical effect on the discount rate used to value future cash flows. Consequently, many growth stocks with lower near-term earnings but high valuations fell and, in some cases, fell dramatically. Having had a stellar decade, growth stocks had the furthest to fall.
This put value is back in the spotlight. Structurally, higher interest rates can provide something of a tailwind for Merchants if and when investors turn to favouring nearer-term tangible cash flows over future potential cash flows from higher growth companies.
Delivering positive outcomes
Despite growth being the investor favourite for many years, the trust didn’t stop delivering positive outcomes for investors. Merchants lead portfolio manager, Simon Gergel, comments: “ We've managed to deliver strong performance, over time, even when value was out of favour.”
So, how has Merchants managed this outperformance? Fellow portfolio manager, Richard Knight, explains: “I think it’s because of this concentration on really identifying good, fundamentally sound businesses. This quality consideration means we've managed to avoid many of the problems, such as “value traps.”
A value trap is when a stock’s price appears undervalued according to the usual metrics, but it turns out it isn’t undervalued after all, it’s just a lower-quality stock, potentially facing structural issues, and not a worthy investment. The Merchants managers use a disciplined approach to carefully construct a portfolio of fundamentally sound, UK companies with attractive valuations. They keenly identify worthy value stocks and aim to avoid the pitfalls of the value trap, concentrating on owning the best companies whilst not overpaying for them.
Merchants’ objective is to deliver above-average income and long-term capital growth. Its track record of consistent, growing income, with attractive long-term total returns illustrates its success to date. It’s even been recognised as an Association of Investment Companies (AIC) ‘Dividend Hero’, making Merchants a potentially attractive choice for income investors.
