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Mind the gap – There may be times when the cheap part of the market is not cheap enough

28/02/2014

Nick Kirrage

Nick Kirrage

Fund Manager, Equity Value

In two recent articles, The Value Perspective has stressed the importance of sticking with your investment process no matter how stupid, mad or just plain wrong other people might accuse you of being. This holds true whether, as an investor, you have been going through some difficult times, as we saw in Short notice, or some good ones, as we ourselves have enjoyed, as referenced in Open-and-shut case.

Without wishing in any way to be seen as showing off, we thought it could be worthwhile to offer an observation on just why one of our portfolios, for the first time ever in its 42-year history, has outperformed its benchmark by more than 20 percentage points for two years in succession.

We have benefited from two things, one of which clearly was that the broader market was cheap. More important than that, however, was the cheapest part of the market was extraordinarily cheap relative to the broader market. Since then, two things have happened. Yes, the broader market has risen – although in our view it is not as crazily valued today as some would have you believe and history suggests reasonable returns can still be made – but that super-cheap part has run right up.

The gap between the super-cheap part of the market and the average valuation is technically known as ‘valuation dispersion’ and this now stands at its lowest level since 2008 – which of course was the last time the market peaked. Unfortunately, this combination of reasonable valuations but low valuation dispersion can muddy the investment waters.

Normally, as value investors, we know the right thing to do – we buy stocks when they appear cheaply valued and sell them when we believe they are expensive. There are times, as we hinted at the start, where doing the right thing might feel distinctly uncomfortable but, nevertheless, we stick to our investment process.

Today, it is less obvious because, with the exception of a few stocks, the cheapest part of the market is not much cheaper than the broader market. As a value investor, you then have to ask yourself whether you really are being paid to take the risk – because those cheaper companies probably are riskier. It is a very interesting question and one currently provoking much debate at The Value Perspective.

Author

Nick Kirrage

Nick Kirrage

Fund Manager, Equity Value

I joined Schroders in 2001, initially working as part of the Pan European research team providing insight and analysis on a broad range of sectors from Transport and Aerospace to Mining and Chemicals. In 2006, Kevin Murphy and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Kevin and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.

Important Information:

The views and opinions displayed are those of Ian Kelly, Nick Kirrage, Andrew Lyddon, Kevin Murphy, Andrew Williams, Andrew Evans and Simon Adler, members of the Schroder Global Value Equity Team (the Value Perspective Team), and other independent commentators where stated. They do not necessarily represent views expressed or reflected in other Schroders' communications, strategies or funds. The Team has expressed its own views and opinions on this website and these may change.

This article is intended to be for information purposes only and it is not intended as promotional material in any respect. Reliance should not be placed on the views and information on the website when taking individual investment and/or strategic decisions. Nothing in this article should be construed as advice. The sectors/securities shown above are for illustrative purposes only and are not to be considered a recommendation to buy/sell.

Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.