A recent Morningstar article discusses the risks associated with value stocks, which are now cheaper than ever.
The article cites a recent report by BlackRock that issued a “stark” warning: “The market needs to fundamentally reappraise the true value of over-indebted, structurally challenged business models, particularly those that are paying dividends they can’t afford.”
So how do investors find real value stocks? The article cites comments from one fund manager, David Keir of TB Saracen Global Income & Growth Fund, who says the most important element is whether a company shows growth potential. He says, “there are many cheap shares in the value bucket, but ultimately if they are in long term decline, it doesn’t matter how cheap they are, they’re a bad place to be.” Things to look for, he said, include: sudden decline in revenue growth; structural issues in the sector; declining margins; weakened balance sheet; and “badly thought-out” merger and acquisition activity.
Tom Wildgoose, co-manager of the five-star rated Nomura Global High Conviction fund, also weighs in: “The value of a company depends on the cash flow it will generate in the future and the shares of a company are only ‘cheap’ if the share price under values those future cash flows.” It’s important to differentiate between companies experiencing cyclical shifts in earnings and those threatened by a more permanent shift. Wildgoose evaluates competitive advantage, return on capital and management skill as part of this process.
“Ultimately,” the article concludes, “companies don’t fall under the value umbrella just because they’re cheap. “Companies in structural decline are being dealt with more harshly than ever before. It is more important than ever to be able to tell the difference between value and value traps.”