Daring to disagree with world's second richest man

If you dig deeply enough, there are plenty of investment gems to be found, writes Jenne Mannion
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The Independent Online

Exactly a year after world stock markets plunged to their lowest point for years, Warren Buffett, the legendary investor, is still sceptical about the valuation of global companies; but UK investment professionals have the effrontery to disagree with the billionaire septugenarian. They say if you dig deep enough there are plenty of gems to be found.

Mr Buffett, 73, chairman of the US investment and insurance company, Berkshire Hathaway, and the world's second wealthiest man, told shareholders in his annual letter this week that he saw few bargains in stocks and bonds. Mr Buffett's letters, which accompany the firm's year-end results, are scrutinised by investors, who pay close attention to his opinions and hope to repeat his investment success.

In the UK, investment commentators agree there are fewer good-value opportunities in global stock markets following the strong bounce that kicked in 12 months ago yesterday. They refute any suggestion, however, that there is a dearth of quality value opportunities to be found amongst UK or global stock markets.

Paul Kavanagh, director of the London-based stockbroker Killik & Co, said: "I'm finding plenty of good companies, or bargains, that have good growth prospects, yet are trading on low valuations relative to the rest of the market and their own historic valuations."

A UK sector where such companies are ripe for the picking is specialist housebuilders, a subsector of construction and building materials. Such stocks include the likes of Persimmon, Wimpey, Bovis Homes, Barratt and Bellway.

The ratio of share price to company earnings expected for 2004, known as the price/earnings ratio (PER), is about six times among specialist house builders, significantly lower than that of the FTSE All Share, which is around 15 times for 2004. "This indicates that house builders are cheap," Mr Kavanagh said. "Investors are pricing in a cyclical downturn in the housing market, which would affect the share prices of these companies. This downturn has been priced in for some years, yet the housing market boom has carried on and profits continue to increase. These companies therefore represent perfect examples of good value opportunities."

And it need not be a sector-based story such as house price trends that pushes companies to represent good value for investors. It can also be very stock-specific, as in the case of the FTSE 100 member and telecom giant, BT Group.

BT is trading on a 2004 PER of around 10 times, lower than the broader market and thus another good-value opportunity in Mr Kavanagh's eyes. He explained that, although BT is currently valued as a "low growth" or "no growth" utility, there could be a turnaround in its fortunes over coming years.

Although Mr Kavanagh has cited certain sectors and stocks as representing good value, there is no universal definition of what constitutes a value company. Investment professionals say it is difficult to know exactly where to draw the line between value and growth.

One simple though flawed definition is based purely on valuations. Under this system, any company with a PER higher than the market's (currently 15 times for the FTSE All Share) is considered a growth company, while any stock with a lower than average market PER is considered a value play. "In reality, there is far more of a grey area," Mr Kavanagh explained. "The definition of value versus growth is far more subjective and considers dividends."

Most fund managers would therefore class a value company as one that generates a lot of cash for which it has little use, thus paying it out to investors in the form of dividends. Some companies in the food producer sector represent good value opportunities, based on their yield. Northern Foods, which has implemented a massive share buyback programme over the past two years, has a current yield of around 6 per cent. "This company's markets are not growing, nor is there a large amount of capital expenditure or reinvestment. But it has a lot of cash with little purpose, so is paying it out in the form of dividends," Mr Kavanagh said.

By contrast, a growth company will reinvest its dividends. Arm Holdings has strong cash on the balance sheet, but that is being reinvested in the business in the pursuit of growth, rather than being paid in dividends.

Investors in a managed fund can opt for managers who favour either growth or value shares. Mark Dampier, an independent financial adviser at Hargreaves Lansdown in Bristol, said there are also grey areas in differentiating between growth and value funds.

However, as a general rule of thumb in the UK market, managers of traditional equity income funds tend to favour value stocks in their pursuit of dividend-paying companies.

The managers of some of the most popular and successful UK funds seek dividends and therefore indirectly opt for value companies. Such, Mr Dampier said, include Jupiter Income's Tony Nutt, Invesco Perpetual Income's Neil Woodford, Credit Suisse Income's Leigh Harrison and New Star Higher Income's Toby Thompson.

"Even though they look for dividends when investing," said Mr Dampier, "they often resent being pigeon-holed as value managers, preferring to be labelled as more pragmatic.

"Mr Woodford is quite adamant he is not labelled a value investor, as he will also buy traditional growth stocks when he finds them attractive. I would say he is a value investor, however, as he looks at dividends and valuations when choosing companies."

One fund available to UK investors where value is an unambiguous aim is the JP Morgan Fleming UK Strategic Value fund, managed by Chris Complin. This fund has been an outstanding performer over the past three years, a period in which stock markets have declined. Over the past 36 months, the average fund in the UK All Companies sector has declined by 13.6 per cent, while JPMF Strategic Value has posted a 22.1 per cent gain before charges, according to Standard & Poors.

Michael Hughes, a product manager on the JPMF UK Strategic Value fund, said that, rather than scrutinising individual companies and analysing their prospects, this fund takes a broad approach to holding stocks that are cheaper than the market average, based on their PERs.

Mr Hughes said: "The fund will buy the cheapest 30 per cent of stocks in the market. The manager will then weed out those that are cheap for a bad reason, such as poor management or financial trouble. There are always some cheaper-than-market-average stocks to be found, and thus there is always good value to be had irrespective of the wider stock market cycle."

Mr Complin's fund, which contains some 150 stocks, has a current average PER of around 10.

While value can be found if delving deep enough into the market, investment commentators agree growth stocks will offer the best opportunities if the stock market recovery continues and investors' appetite for risk increases. "Traditionally, value stocks will outperform in a falling market while growth stocks will do better in a rising market," Mr Dampier said. "But a good investor should be able to pick the best of both worlds."

WHAT THE ANALYSTS SAY

BT Group may be a sleeping giant to many investors, but to Killik & Co it represents a strong buy opportunity. Paul Kavanagh, a director at Killik & Co, said BT offers a rosy future for two key reasons.

"While the group's core residential fixed-line earnings are under pressure and exposed to further reductions in market share and tightening regulatory price reviews, the outlook is not as difficult as the market's valuation implies, with shares currently yielding 5.7 per cent," he said.

"Second, BT is enjoying a rapidly expanding earnings stream for its residential broadband product. The broadband division reached its target of two million subscribers in January 2004, 10 months ahead of schedule."

Mr Kavanagh also classifies Unilever, the food producer, as good value. Although the 400 brands under Unilever's name grew by only 2.5 per cent in 2003 and it under-performed its peer group over the past year, at current prices there is room for a rebound.

The chairman, Niall FitzGerald, is to retire in September and be succeeded by the foods director, Patrick Cescau, and the group will embark on a strategy designed to deliver stronger shareholder returns. This will be driven by the generation of free cashflow, developing its return on invested capital and managing its weighted average cost of capital. Mr Kavanagh says the group plans to use its free cashflow to reduce debt, which could take the form of a share buyback programme or an enhanced dividend.

Michael Hughes, product manager at JPMF, said there are a number of prominent stock opportunities which his UK Strategic Value fund has identified. He said: "Royal Bank of Scotland is trading at a 35 per cent discount to the market on earnings-based valuation metrics, despite beating analyst expectations with full-year 2003 results and growing earnings by over 10 per cent per annum."

Another is British Airways. Mr Hughes said that, despite making a loss last year, the stock is cheap because of its prospective price/earnings ratio, as significant cost-cutting coupled with revenue uplift has led to improved earnings.

Among international stocks, David Currie, manager of the Isis North American fund, likes Duke Energy. He describes this as a turnaround story with new management which is refocusing on the core business of regulated power supply. The stock yields more than 5 per cent.

"Another we like is AllState," Mr Currie said. "This is an insurance company which currently yields 2.5 per cent, but is well positioned to pay higher dividends in future."

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