Why it takes more than a big share price fall to pique our interest
Value investing involves a lot more work than simply tracking down a list of the companies whose share prices have fallen most and taking that as a proxy for value
At its heart, value investing involves buying stocks that trade at a significant discount to their intrinsic worth and then selling them in the event the wider market catches up with your own assessment. As such, you would think a large fall in a company’s share price would be of great interest to us – but no, we source ideas from an academically proven value screen and here is why.
AO World is a UK-listed online white goods retailer and, shortly after it floated in February 2014, it saw its share price hit a high of 377p. By the start of this year, however, the share price stood at almost exactly half that – at 188p – since then it has dropped by around a third further to reach 125p. A green light for value investors then? Well, let’s see.
One key measure investors can – and, in our opinion, should – use to gauge whether a business is of potential interest is reached by dividing its enterprise value (EV) – essentially its total value, including debt and other adjustments – by its earnings, before interest and tax are taken into account (EBIT). AO World’s EV is currently £580m while the highest EBIT it has made in a single year is £8.5m. So that is an EV/EBIT figure of 70x.
Now, here on The Value Perspective, we would much rather use a company’s average annual figure to guide our view of normalised earnings rather than its peak earnings. In this instance, however, that is not possible as AO World averages a loss of £2m per year. We would then look to buy businesses at less than 10x their normalised EBIT and yet – despite its huge share price falls – this AO World ratio is seven times the multiple we would like to pay at 70x!
For value investors, that is extraordinarily, eye-wateringly, no-point-going-any-further expensive. A dead end. Even at today’s significantly reduced price, any investor who buys into AO World is relying on what is known as ‘Bigger Fool Theory’ – the idea there will be a bigger fool out there willing to buy the shares off them at a price that will enable them to make a profit.
Conversely, to be a proper value investor, you need to do a lot more work than simply tracking down a list of the companies whose share prices have fallen most and taking that as a proxy for value. The distinction – as is often the case in investment – is neatly captured by Warren Buffett, who famously observed: “Price is what you pay. Value is what you get.”
Fund Manager, Equity Value
I joined Schroders in 2008 as an analyst in the UK equity team, ultimately analysing the Media, Transport, Leisure, Chemicals and Utility sectors. In 2014 I moved into a fund management role and have had experience managing Global ESG and Pan-European funds. I joined the Value investment team in July 2016 to focus on UK institutional and ethical-value portfolios.
The views and opinions displayed are those of Nick Kirrage, Andrew Lyddon, Kevin Murphy, Andrew Williams, Andrew Evans, Simon Adler, Juan Torres Rodriguez, Liam Nunn, Vera German and Roberta Barr, 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.