INVESTMENT TRUSTS

Ignoring the herd: finding value in unloved areas

We explain why hunting in unpopular parts of the market may uncover exciting opportunities – and why it might be particularly fruitful at the moment.

Capital at risk. The value of investments and the income from them can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested.

Buying when shares are cheap and selling them when they are expensive should be the first rule of investment, but it is not always easy to do in practice. It is a little like looking at the last loaf in the baker’s shop: investors don’t spot a bargain, they wonder why no-one else wanted it. However, done right, hunting in unloved areas could prove fruitful.

There are plenty of sound reasons why a particular segment of the market may be unloved. It may be in a declining industry, or it may have suffered a period of weak performance. Companies may have suffered a scandal or seen management instability. However, in financial markets, companies will often be unloved simply because investors’ attention has been lured elsewhere. In this case, there may be an opportunity to pick up higher growth companies at lower valuations.

A focus on technology

Today, we believe that many companies have been left behind by investors’ narrow focus on a handful of technology companies. In a difficult climate, investors have preferred the apparent safety of reliable earnings. The problem is that the share prices for these ‘loved’ sectors have grown more than their earnings, leaving valuations very high1.

In contrast, the unloved sectors have fallen more than any weakness in their earnings or – in some cases – in spite of real strength in their earnings: the UK has been unloved because of Brexit; frontier markets have been unloved because of a flight to safety; Latin American markets have been unloved because of their COVID-19 response.

At BlackRock, our portfolio managers believe this can provide the most fertile hunting ground. Often the weakness in share prices has exceeded the real threat to individual companies, which allows us to uncover real long-term value. We have a number of investment trusts focused on these unloved areas – frontiers, UK smaller companies, Latin America, the mining sector and niche areas within the European markets.

Investor behaviour

There are well-established behavioral reasons why this happens. Investors tend to be reassured by the actions of others. If lots of people are buying into a particular area, it feels like the right thing to do. Fund flow patterns have long shown that investors buy after a period of strong performance. More flows drive up stock prices, which attracts more investors, which drives up stock prices and so on.

However, there comes a point where the music stops. As has been shown in stock market bubbles throughout history, the worst time to buy is often when there is most excitement around an individual sector – from dotcoms to tulips.

Buying into unloved areas is difficult. It means going against the herd; an investor needs to trust their own instincts about the prospects for an individual company or sector. However, it can be effective. It means buying when prices are low rather than when they have already moved a long way.

“Today, we believe that many companies have been left behind by investors’ narrow focus on a handful of technology companies.”

 

Buy the unloved

For the past 25 years, data provider Morningstar has run a ‘Buy the Unloved’ strategy, which invests equal sums in the three equity Morningstar Categories with the largest calendar-year outflows while avoiding those with the heaviest inflows. After three years, sell the stakes and invest the proceeds equally in that year’s unloved categories.

The group has found that the unloved portfolio has beaten the loved one, the three most “loved” categories in terms of inflows of the previous year, by more than 5.8 percentage points annually from January 1994 through the end of 20182.

BlackRock’s depth of resources

There are always risks to hunting in unloved areas. As the retail sector has shown, some companies may be unloved with good reason. However, that’s where sound analysis comes in. By looking at business models and cash flow, by talking to the management team and by assessing a company’s long-term prospects, it is possible to work out whether a company is structurally challenged, or just unpopular.

At BlackRock, we can call on vast analytical resources when making these judgements. This helps our portfolio managers assess the risks inherent in each company and look at whether they represent a real opportunity or a value trap. As it stands, our investment trusts are investing in exciting growth areas as yet unappreciated by the market. We believe investors will ultimately start to appreciate the potential for these companies.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or financial product or to adopt any investment strategy. The opinions expressed are as of October 2020 and may change as subsequent conditions vary.

  1. Macro trends, October 2020
  2. Morningstar, February 2020