LONDON: Studying the portfolios of the world’s best fund managers, we’ve unearthed their 25 favourite value plays.

Oil, energy and banks are big themes.

A common problem investors face when screening the market for value stocks is that rather than unearthing underappreciated opportunities, they get value traps.

But what if the starting point when hunting for value are stocks that have already been vetted by the world’s best fund managers? Does this help sort the wheat from the chaff?

We’re giving it a whirl. The question of whether companies are fixing the future has been left to one side for this exercise.

Here’s how we’ve put our screen together, followed by the results.

STEP 1: The hunting ground

Citywire’s unique Fix the Future database has details of all the 7,000-or-so stocks held by the world’s best fund managers – about the top 5%. However, not all these elite investors’ holdings should be considered equal.

Managers place much bigger bets on their favourite stocks. And when managers really put their necks on the line by going heavily overweight, they’re likely to have devoted a lot of resource to checking they aren’t backing a dud.

Researchers have found evidence that funds’ most overweight positions tend to convincingly outperform other holdings.

We’ve developed a scoring system that allows us to assess the collective conviction of all the elite managers we track toward every stock in our database. To try to minimise our chances of stumbling on value traps when screening for value, we’ve used our conviction rankings to concentrate our hunt for cheap stocks on the most popular tenth of shares in our database.

STEP 2: The hunt

Stock valuations tend to reflect the investment merits of the company that has issued the equity. While high valuations are typically associated with companies with attractive characteristics, such as high growth and high profitability, low valuations usually reflect a company with problems.

However, when the outlook is very challenging for a company or sector, investors have a tendency to become overly negative. This is when opportunities may arise as a result of valuations getting too low.

While the classic value investing approach of buying the cheap stuff has not worked too well over the past 15 years, it remains one of the best- and longest-established ideas in investing. It was originally popularised by Benjamin ‘father of value investing’ Graham in the 1930s and given statistical clout in the 1990s by Eugene Fama and Kenneth French – two rock stars of finance academia, if that’s not too much of an oxymoron.

Value fans have several reasons to hope rising interests will revive the fortunes of this recently maligned investment approach – these reasons range from rising ‘discount rates’ reducing the value of earnings growth to the reinvigoration of the capital cycle as so-called ‘zombie companies’ go under.

Our hunt is based on simply looking for the cheapest stocks among the favourite tenth of shares held by the world’s best funds. This a rather purist ‘value’ approach but by focusing on only top elite stocks, the hope is it should not prove as naïve as would otherwise be the case.

What we’ve screened for

We require stocks have a rating based on at least three of our valuation measures to qualify for the screen.

STEP 3: The haul

Some noteworthy themes emerge from the 25 cheapest elite shares. For one thing, the 25 are certainly cheap, which suggests elite managers have little problem with playing the value game.

The average forecast PE of the 25 is just 6.3 while the average dividend yield stands at a hearty 5%. FCF yield meanwhile averages a handsome 16% and the average PEG is just 0.65.

The cheapest of the cheap

The first sector theme to stand out from our list is the preponderance of oil and energy companies. And there is a mixture of ‘brown’ and ‘green’ plays. Some are focused on renewables, such as UK power producer Drax (although there are sceptics about the virtues of the wood pellets it burns as green fuel), while others are in the foothills of their transition from less climate-friendly activities, such as Shell and Total Energies.

Most of these companies are currently reporting bumper profits on the back of incredibly high selling prices caused by events connected to Russia’s invasion of Ukraine and the restarting of the global economy after Covid-19 lockdowns.

However, as the chances of recession grow, in part because of higher energy prices, the circumstances that these companies have recently benefited from could sow the seeds of downfall too. Already the oil price, which some had predicted to hit $200 a barrel, has fallen below to levels it was at before the war in Ukraine. Having peaked at more than $120 per barrel, WTI Brent Crude now sits below $90.

These companies’ activities are also becoming increasingly politicised from talk of windfall taxes to calls for more action on climate change.

So the low valuations of these companies reflect expectations that the good times for profits experienced in 2022 won’t last.

Financial companies, and especially banks, are another standout theme.

While the recent spate of interest rate increases by central banks to counter inflation should benefit the profitability of banks, a cost-of-living-induced recession could cause a surge in provisions and impairments related to bad loans.

Chinese banks have a noteworthy presence in the list of cheap stocks. These institutions face the added worry of a collapsing property market, which could have far-reaching and systemic consequences for the sector.  

Cyclical companies also feature heavily. With a recession brewing, a number could face falling demand and declining pricing power at the same time as costs surge.