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Value – A Once In A Decade Opportunity?

04 Aug 2016

Alessandro Laurent, Head of Systematic Strategies

Over the last nine years, those who positioned themselves as value investors have not had an easy time of things. We take a look at why they suffered the levels of underperformance seen and why we think that the markets are turning.

In the last nine years value investors have experienced dire results, significantly underperforming growth strategies as well as passive, cap-weighted indices. As shown in Figure 1, the performance differential between global value and growth strategies over this period has been over 30%, reaching levels only experienced during the dot com bubble of the late nineties.

Figure 1 Performance of value vs. growth (global)

There are probably several reasons that might explain the underperformance. First, the global financial crisis heavily affected the financial sector. Banks, which are generally value stocks, still bear the scars of what happened in 2007/08. Stricter regulations, as well as the interventions of central banks worldwide, and the lowering of interest rates, have all sharply reduced banks’ profitability. The impact of central banks’ quantitative easing programs had another unintended consequence: the search for alternative income. Investors who used to get income from the bond market, moved into the equity market and in particular defensive, high yielding securities. Figure 2a shows the performance of US companies with the highest dividend yield versus the performance of US companies with the lowest yields1. From 2008 onwards the divergence in performance between high yielding and low yielding securities has been increasing. At the same time – as shown Figure 2b – high yield stocks are getting more expensive. For the first time in the last 30 years, price-to-book (P/B) and price-to-earnings (P/E) multiples of high yield securities are higher than for low yielding stocks. High dividend paying stocks, which were normally part of a standard value portfolio, have become too expensive in the last eight years to be included. Finally, the end of the commodity super-cycle that affected the mining and energy sectors, contributed indirectly to the underperformance of value strategies.

 Time to Invest in Value

The current economic and financial landscape is obviously very different from that of the late nineties. Nevertheless, there are similarities. A small group of securities are becoming relatively more and more expensive, while at the same time valuation spreads are widening. These conditions are not normally sustainable for long periods of time. If the last rebound in value from extremes is indicative, we could see a powerful recovery of value strategies. It might, therefore, be a very interesting time to be a value investor.

 

Figure 2a The search for income: performance between high yield and low yield stocks

The current economic and financial landscape is obviously very different from that of the late nineties. Nevertheless, there are similarities. A small group of securities are becoming relatively more and more expensive, while at the same time valuation spreads are widening. These conditions are not normally sustainable for long periods of time. If the last rebound in value from extremes is indicative, we could see a powerful recovery of value strategies. It might, therefore, be a very interesting time to be a value investor.

Time to Invest in Value

 

Figure 2b The search for income: valuations of high/low yield stocks

 Time to Invest in Value

Value graph

A SMOOTHER JOURNEY

Despite having significant exposure to value, our Equity Value Strategies have experienced much better performance

over the last few years when compared to more traditional value strategies. The reason for this is only partially explained by the inclusion of other risk factors, such as quality and growth, in our stock selection model.

Risk factors are not independent from one another. Investing in a certain risk factor implies exposure to other risks. In the case of value, for instance, we showed previously the link between high value and high yield stocks and how this link has changed in the last few years. Other externalities associated with value are a strong weight toward particular sectors (e.g. financials) or a negative exposure to momentum.

Isolating the different risk factors from their externalities is key. When we invest in value, we don’t want to just invest in particular sectors or underperforming (i.e. negative momentum) companies. We select the highest value stocks across all sectors and across the whole spectrum of past winners and past losers.

Figure 3 shows the theoretical performance of a long/short strategy based on book-to-price (B/P) (the most studied and commonly used value factor). While a traditional or raw B/P strategy (blue line) exhibits a similar returns path as the one reported in Figure 1, a clean version of the same strategy (green line) in which book-to-price is isolated from other risk factors, drastically mitigates the drawdowns. While the performance of the cleaned B/P strategy from 2007 onwards is far from being optimal, it is significantly better than the one of a traditional strategy. Moreover, the cleaned strategy performs as well as the traditional one in periods when value is particularly strong.

Figure 3 The importance of isolating the risk factors: simulated performance of a long/short strategy based on cleaned and raw book-to-price

Time to Invest in Value

FACTOR TIMING

Despite being confident that the underperformance of value seems unlikely to continue for much longer, we believe that timing risk factors properly is an impractical task. For this reason, we have tried to find an investment strategy that combines different risk factors in such a way that a steady mid to long term performance, with the avoidance of long periods of underperformance, could be achieved.

Figure 4 shows the combination of simulated and live results (from April 2015) of one of our strategies. The blue line represents the outperformance of the US Equity Value Strategy over its reference benchmark.

Figure 4 Simulated and live results of the 7IM US Equity Value Strategy

 Time to Invest in Value

 Time to Invest in Value

The shaded pink areas are the relative drawdowns (rhs) while the boxes at the bottom represent the annual relative performance. When compared to Figure 1, you can observe the link between the results of our strategy and the effectiveness of a traditional value one. In periods when value performed particularly badly, for instance 1988 – 1992, 1998 – 1999 and 2007 – 2015 the strategy experienced below average performance. The drawdowns during these periods however were significantly lower than the one experienced by traditional value investors.

On the other hand, the strategy significantly outperformed its benchmark during periods favourable to value. In other words, the strategy seems to capture the upside while managing to limit the downside.

Another way to show the convex nature of the strategy is to compare the active performance of our value strategy against the relative performance of value versus growth. Figure 5 shows the rolling 12 months active performance from Figure 4 against the 12 month rolling performance of value versus growth from Figure 1.

Time to Invest in Value

 

CONCLUSIONS

In the last few years, the discrepancy in performance between growth and value stocks has reached a point close to the one experienced during the dot com bubble of the late nineties. We believe that such underperformance is not sustainable for much longer and that value provides a great opportunity in the near future. If the last rebounds in value from extremes are indicative, we could experience a significant come back in value strategies.

Although we don’t know exactly when this will happen, as it is extremely difficult to successfully time factors, we do know that our equity strategies should profit significantly from a rebound in value. In the meantime, while waiting for this to happen, we are still able to deliver outperformance. To quote Edmund Burke the 18th century Irish/British Statesman, our patience will achieve more than our force.

Alessandro Laurent
Head of Systematic Strategies

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The value of your investments and the income from them may go down as well as up, and you could get back less than you invested.
The value of your investments and the income from them may go down as well as up, and you could get back less than you invested.

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