Earlier this week, I was chatting to a friend who, like me, is a passionate investor. He was concerned about some of his FTSE 100 ‘value’ holdings. “My value portfolio is seriously underperforming,” he told me.
This seems to be quite a common problem at the moment. In recent years, a lot of FTSE 100 value stocks have produced disappointing returns. Many ‘cheap’ stocks – including the likes of BT Group, Centrica, and Imperial Brands – have become even cheaper.
With that in mind, today I want to take a closer look at the concept of value investing. Specifically, I’d like to draw your attention to what Fundsmith portfolio manager Terry Smith – who has turned £10k of investor money into more than £45k in less than a decade – has to say about this style of investing.
Value investing has its flaws
In his most recent annual letter to Fundsmith investors, Smith said that, in his view, value investing has its flaws as a strategy.
“Markets are not perfect but they are not totally inefficient either and most of the stocks which have valuations which attract value investors have them for good reason — they are not good businesses,” he wrote.
Smith points out that cheap companies tend to generate “inadequate” returns on capital (meaning they’re not very profitable) and that often, they are facing headwinds. As a result, the intrinsic value of these companies often doesn’t grow much over time.
Smith also argues that value investing is not a true buy-and-hold strategy as it involves buying low, attempting to sell at a higher price, and then starting the whole process all over again. As well as being a more complicated process than simply buying and holding for the long term, it also involves increased trading costs.
A better approach?
Instead of chasing value, Smith believes investors are better off focusing on higher-quality companies that consistently generate strong returns on capital, even if they’re a little more expensive. His view is that over the long run, portfolio returns tend to be in line with the returns generated by the companies in the portfolio themselves, “which are low for most value stocks.”
Here, he borrows a great quote from Warren Buffett’s business partner, Charlie Munger: “Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns six percent on capital over forty years and you hold it for that forty years, you’re not going to make much different than a six percent return – even if you originally buy it at a huge discount. Conversely, if a business earns eighteen percent on capital over twenty or thirty years, even if you pay an expensive looking price, you’ll end up with one hell of a result.”
I think this wisdom from Smith is certainly something to consider if your value approach to investing is not delivering the results you desire. Instead of buying stocks just because they’re cheap, it could be a better idea to invest in high-quality companies that are very profitable, and hold for the long term while they compound their returns. The FTSE 100 has plenty of them. As Buffett says: “It’s far better to buy a wonderful company at a fair price, than a fair company at a wonderful price.”
Edward Sheldon owns shares in Imperial Brands and has a position in the Fundsmith Equity fund. The Motley Fool UK has recommended Imperial Brands. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.