As the impact of coronavirus and the resulting response by global policymakers becomes clearer, the stock market will continue to react. Share prices will move up and down reflecting the perceived winners and losers of this developing situation. However, the “true” value of businesses typically changes very slowly over time.

Coronavirus is very concerning for the human race and the threat of a global oil price war is unnerving. However, many experienced market participants who take a long-term view say such events should not impact the way investors think about stocks. Investors should not, they caution, buy or sell businesses based on news headlines.

Value investing involves taking a long-term view. Here are some answers to questions about value investing and how it performs in challenging markets.

How do investors work out a company’s true value?

This involves ascertaining the true value of companies based on their “fundamentals”, such as their profit-generating potential, and financial, or balance sheet strength. It involves buying companies whose shares are trading below their true value, so attractively valued, and selling them when they are trading above their true value.

Such investors believe stock markets tend to overreact to both good and bad news, thereby allowing them to take advantage of resulting price distortions. This approach is called value investing.

Does value investing offer an attractive proposition in challenging markets?

Value stocks are often businesses that, having had one near-death experience, are doing their utmost to avoid having another. Such companies tend to be prudently managed, with solid balance sheets and are therefore potentially prepared to weather what the future has in store, although each situation needs to be analysed on a case by case basis.

But haven't many value stocks underperformed as markets have sold-off?

It’s true that the market reaction has been to sell value stocks in the commodity and financial sectors. This is perhaps unsurprising given fears around the impact of coronavirus on the global economy as these are economically sensitive areas of the market.

However, these companies have some of the strongest balance sheets in the world today, which, when coupled with their attractive valuations, and a rigorous selection process, makes some of them worth considering for those willing to take a long-term view.

The detailed work involved in ascertaining a company’s true value, and testing its fundamentals in a wide range of possible future economic scenarios, may not be a “virus outbreak test”. However, it is a severe financial stress test, akin to the conditions that businesses endured through the 2008/09 global financial crisis.

How has value investing performed following past periods of market turmoil?

Schroders’ Head of Research and Analytics Duncan Lamont has explored the question of how stock markets perform in a crisis: ‘How does the stock market perform when the VIX fear gauge surges?’ The data shows that, rather than being a time to sell out of the stock market, periods of heightened fear have been when investors have historically earned better returns.

Intuitively, you might think things would be different for value stocks. That if investors are already pessimistic about a company’s prospects, as is often the case for value stocks, they would be even more worried about them in such an environment. And their stock price would suffer. But this turns out to decidedly not be the case. Historically, if you had invested in value stocks when markets were in panic mode, you would have earned a higher return than if you invested at any other time.

Using data since 1991, we analysed how value stocks (Russell 1000 Value index) have performed when the market’s fear gauge, the VIX, has been at different levels. The VIX reflects the amount of volatility traders expect for the US’ S&P 500 stock market index[1] during the next 30 days.

When this index has been high, strong returns have usually followed. On average, value stocks have returned around 25% in the 12 months after the VIX exceeded 33. It should therefore be noted that the VIX spiked to nearly 60 on 9 March, up from its normal recent range of 10 to 20.

Next 12 month return on Russell 1000 Value based on different starting VIX

Each range corresponds to 5% of historic experience for the VIX

As with all investment, the past is not necessarily a guide to the future but history suggests that periods of heightened fear, as we are experiencing in at present, have been better for value investing than might have been expected.

So will value investors be maintaining their same approach amid current events?

Yes, they will continue to spend the vast majority of their time poring over company reports and accounts to answer the question: ‘Is the balance sheet good enough?’ This is because arrangements that appear sustainable in today’s benign environment are often onerous in more difficult times.

They will remain focused on ascertaining the true value of companies and unafraid to buy when others are fearful, in line with their long-term approach.

Kevin Murphy, Fund Manager, Equity Value, says: ‘We don’t know where share prices will settle over the coming months. No one does. However, we will act as we always do, going wherever the value is in the market. Buying things that others find uncomfortable, and often buying things that others currently believe are tainted. As those negative perceptions and issues alleviate, share prices rebound.’

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.

The views and opinions contained herein are those of the authors, or the individual to whom they are attributed, and may not necessarily represent views expressed or reflected in other communications, strategies or funds.

This information is not an offer, solicitation or recommendation to adopt any investment strategy.  If you are unsure as to the suitability of any investment please speak to a independent financial advisor.

[1] A stock market index that measures the performance of the 500 largest US quoted companies.