How to identify undervalued assets
Warren Buffet is considered a deep value investor, prepared to wait for an asset's value to rise when investing on a deeply discounted basis. However, there are a number of types of value investors - all seeking to invest whilst assets are undervalued, reaping the rewards when their value rises again.
Value investing’s underlying principle is to identify assets that are not fully priced, with the view to benefitting from the rise in the asset’s value over time.
For Nader Naeimi, Head of Dynamic Markets, AMP Capital, this is the focus of his work.
He applies the principles of value investing in a professional sense when managing his portfolio. Self-managed super fund (SMSF) investors can apply many of the same principles to their own investment strategies.
One of Naeimi’s insights is to use the notion of value investing for asset classes rather than individual assets, to help reduce risk.
“When an asset class is undervalued, it is priced well below its potential in terms of earnings or income growth. It has the ability to grow more or produce more income than is currently appreciated by investors in the market,” he explains.
But it’s important to understand why an asset is undervalued. Market sentiment is often one reason.
“Sentiment can push an asset class below or above its growth potential. This happens because investors extrapolate past trends into the future,” says Naeimi.
“Value buying can be a lonely game because you're going against the trend,” he says.
Value investing often involves identifying assets or asset classes that are underpriced after going through a challenging period.
Says Naeimi: “Maybe the asset class or its income has come under pressure and market sentiment has turned sour. To go against that, you need strong conviction to be able to separate the noise from the signals.”
Objective analysis is essential to identify undervalued assets. “You need analysis, experience and good judgement. We spend a lot of time looking for asset classes that are inexpensive. But that’s just one box we tick.”
“The asset class must also be backed by news and the fundamental story. You don’t want to see an asset class that’s cheap become even cheaper after you have invested in it,” he adds.
There are also different types of value investors. For instance, Warren Buffett is considered a deep value investor. Investors in this class hope to invest on a deeply discounted basis and are prepared to wait for the asset’s value to rise.
An example is Buffett’s decision to buy financial services businesses during the depths of the financial crisis of 2007/2008. This turned out to be a good decision as this industry has improved its performance over time.
“The analysis you do is a lot more detailed when you’re executing value buying at the company level because you have to understand the companies in great detail to ensure you’re really buying a value asset. It’s essential you’re not buying into a value trap,” says Naeimi.
“Whereas when you buy at the asset class level, for example, buying a sector such as banking, you don't need to understand the ins and outs of each stock. It’s also unlikely the sector as a whole will go bankrupt, and that reduces risk,” he adds.
SMSF investors can use the same principle, undertaking research to understand individual asset classes that are undervalued, rather than trying to find specific stocks that are under-priced. This also helps reduce risk.
The energy sector is a good example. Assets in this category are undervalued as a result of pressure on the oil price.
Market sentiment is overly-focused on the rise of new technologies such as electric cars reducing the demand for oil. But this could be myopic, given oil has many other uses other than in vehicles. Its use in aviation fuels, agriculture, forestry and manufacturing, for instance, is unlikely to diminish in the medium-term.
The global ship building industry is another example. Shipping underwent a downturn in recent years as global trade fell. But although there has been a downturn, trade and demand for shipping is starting to rise. Yet the sector is priced at levels consistent with ongoing recession in global trade, despite the increasing signs of a strong recovery in global trade.
Naeimi has made allocations to both the energy sector and the global ship building industry in the ASX-traded AMP Capital Dynamic Markets Fund (Hedged) (ASX: DMKT)
“When you're buying things that are undervalued, ensure the situation is not going from bad to worse. Look for asset classes with strong improvements in underlying fundamentals and the potential for strong future revenue streams and don’t be afraid to have the courage of your convictions,” Naeimi adds.