Did the value recovery finish before it started?
Despite the recent renaissance of so-called ‘value’ investing, sustained underperformance has wiped out the longer-term gains traditionally attributed to this style of investing. Yet headlines and fund manager communiques remain full of hope for the sector.
Is value investing dead forever? Or what is even alive? These are questions that Invesco’s Australian Equities team recently asked in their ‘Value: The Post Mortem’ white paper.
Looking at the construction of most model portfolios today, they are dominated by mega cap growth names, which Invesco attribute to the fact that advisers are have begun to ‘question the ongoing viability of value investing as a whole’.
But perhaps we are looking at it the wrong way? This is the proposition of the Australian Equities Team, whose factor-driven investment process is focused on identifying those ‘factors’ that are able to provide persistent returns over time; the likes of Size, Quality and Momentum among them.
They suggest the term ‘value’ is being misused in place of a ‘valuation’ driven approach.
It is clear from the plethora of data available that a tilt towards basic valuation metrics like the Price to Earnings or Price to Book ratio along has not provided any reliable return enhancement, so what does this mean for value investing? Does this mean that investors should give up on value? Or is the market of the last decade a poor guide for value returns? These are among the questions asked by the team.
According to the whitepaper, the actual return benefit from ‘value’ investing is not merely ‘driven by a simple tilt towards value stocks’ using the ratios mentioned above. We know this basket of stocks incredibly well, they operate in cyclical industries like commodities and retailing, and have significant economic sensitivity.
It is this economic sensitivity that makes them ‘cheap’ on traditional measures and means they perform strongly in conditions like the last six months, where a broad economic recovery offers a strong boost. The issue that Invesco highlight is that reliance on basic valuation measures leaves investors prone preferring just a few highly cyclical sectors.
The solution, they suggest, is sector neutralisation, removing these biases to offer exposure to a basket of stocks that benefit from a ‘relative value’ factor, rather than the traditional valuation factor. Evidence suggests the returns from this factor are more consistent and persistent over time, as well as being more easily identifiable.
Value is dead
Despite the headlines, Invesco suggest that it is still possible to use value factors in quantitative investing if applied in a ‘relative’ sense. ‘A tilt towards cheaper stocks amongst a reasonably homogenous set of industry peers’ can add to long term returns, but the key is to ‘compare stocks with a similar growth outlook and industry dynamics’ to ensure their pricing to near term financials is more meaningful.
Their process involves identifying more persistent value factors, which act to remove the bias towards just a few traditional ‘value’ sectors. The provide the example of an Adjusted Cash Flow Yield compare to traditional price-driven ratios, which is shown to have delivered strong outperformance even during the growth decade. They say ‘This is the effect of relative value investing within a peer group, which identifies cheap stocks rather than just cyclical industries.’
Concluding, they suggest that to a quantitative investor, a ‘value’ tilt is ‘more intra-industry based, less pronounced than fundamental’, which results in less ‘thematic cyclicality’ within portfolios. They find the best application of relative value is to guard against the excesses of growth investing, while exposing the portfolio to rebounds in value.
Finally, in what may be a concern for those allocating to traditional value stocks today, they note that the rotations for traditional ‘value’ stocks like the one we are experiencing today, typically lasts 12 months or less.