After a decade of poor performance, the value factor appears to be in the early innings of a comeback. From September of last year through February of 2021, the Russell 1000 Value Index outpaced the Russell 1000 Growth Index by 13.8 percentage points, leaving devotees rejoicing.
Has it returned for good, or is the value factor just teasing its fans? Regardless of what the future holds, citing the performance of a value index masks the incredible performance gaps across different value investing strategies. For example, Invesco S&P Pure Value ETF (RPV) trounced the Russell 1000 Growth Index by 31.7 percentage points, while the FlexShares Quality Dividend ETF (QDF) outperformed by only 3.7 percentage points.
That massive performance disparity between RPV and QDF is closely tied to the way each fund approaches value investing. RPV favors stocks with dirt-cheap multiples, weights them by the strength of their value characteristics, and pays little attention to the underlying quality of its holdings. On the other hand, QDF looks for high-quality companies then holds those with higher yields than the market, which pulls it toward the value side of the Morningstar Style Box.
These two strategies exist at opposite ends of the value investing spectrum. One end houses portfolios with lower-quality, cheaper stocks. The opposing side features portfolios of high-quality stocks with correspondingly higher price tags. Exhibit 1 illustrates this relationship between price and quality. It includes all exchange-traded funds and open-end mutual funds in the large-value Morningstar Category and plots each fund’s average price/book ratio against its profitability, as measured by return on invested capital (a proxy for quality).
There is a clear relationship between price and quality. Funds typically trade off one trait for the other. Those at the far ends of this spectrum typically hold very different types of stocks. These stocks are different in the sense that they don their relatively low valuation multiples for different reasons. Understanding the forces pushing their multiples down has implications for the risks they bear and their expected performance.
Sick Companies
William Bernstein, the financial advisor and noted author, offers one of the best descriptions of value strategies, referring to them as the financial equivalent of an intensive care unit: a ward “containing vast numbers of companies maintained on the fiscal equivalent of ventilators and potent antibiotic and heart medicines.” [1]
That description paints a rather ugly picture, but it contains a notion of truth. Bernstein’s “sick company” metaphor readily applies to stocks at the low end of the price range because their businesses are often struggling, for any number of reasons, and they tend to have highly uncertain outlooks. They are decidedly not healthy. The market likely recognizes that and doesn’t expect them to perform well, so it assigns a lower price to give investors incentive for bearing their risks.
RPV lands on the intensive care registry, as does the SPDR Portfolio S&P 500 High Dividend ETF (SPYD). Both portfolios have some of the lowest average price multiples and profitability among funds in the large-value category and have proved riskier than the Russell 1000 Value Index. Compared against that benchmark, their standard deviations are often higher and their drawdowns deeper, as Exhibit 2 shows.
Sector biases further complicate the situation. Holding the cheapest stocks in the market causes RPV and SPYD to be overweight in cyclical segments. Both are top-heavy in energy and financials and share similarly large stakes in companies like Exxon Mobil (XOM) and American International Group (AIG), making them more sensitive to market movements than the Russell 1000 Value Index.
Some of the funds in this cohort may possess another element of risk that isn’t easily observed in traditional risk metrics. Funds holding names with the lowest valuations or those with high trailing yields tend to have exposure to stocks with recent price declines or negative momentum. These stocks are likely to continue performing poorly in the near term and subtract from their fund’s overall performance.
In Part 2 of this article, we will continue to explore value strategies.
References
1. Bernstein, W. 1999. “Value Stocks: Hidden Risk or Free Lunch.” http://www.effi-cientfrontier.com/ef/999/risk.htm
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