October 2017

SMART BETA: A cheap blonde

BlondAfter a period of outperformance in 2016, Catherine Lafferty asks if the value factor has gone out of fashion.

As a factor, value has its enthusiasts and sceptics, which isn’t to say that sceptics dislike it. It’s like the difference between blondes and brunettes, one fund manager says, characterising value as a cheap peroxide ‘number’, all stiletto heels and fake tan.

Ana Harris, portfolio strategist, global equity beta solutions at State Street Global Advisors (SSGA), describes value’s perennial attractions. “It is about companies that are cheaper relative to the broader market and deliver stronger returns over the long term,” she says.

Value is a characteristic primarily tested in the equity market but which has also been observed in the fixed income market. As an approach, value considers whether a company is undervalued relative to fundamental characteristics.

Investors will try to identify what the intrinsic value is and compare it with what you can buy it for – its stock price – and if, as tends to happen, these value opportunities are found in sectors experiencing some sort of transformation.

Value tends to have spikes of outperformance following periods of dormancy. It has performed well recently, though as is sometimes the case with dizzy numbers, there is some vagueness about when the good time started and whether it has ended.

Chris Mellor, executive director in equities product management at PowerShares, says: “It tends to be volatile, underperforming for long periods and then spiking very aggressively. But when value works, it really works.”

It worked in 2016, rallying strongly through the six months from June to the end of December.

Yazann Romahi, chief investment officer for quantitative beta strategies at JP Morgan Asset Management, says: “It is difficult to pinpoint a single driver of the value spike in 2016. Value companies were certainly at extreme levels of cheapness by the middle of 2016 and it was therefore a matter of time before a normalisation took place.”

Improving global growth and higher inflation expectations, and the potential for higher interest rates, may all have served as a catalyst. However, Romahi stresses that this was not specifically driven by the result of the US election.

The blonde’s outperformance wasn’t thanks to the blond who won the race to the White House, in other words.

Although market expectations around future economic policy may have helped to enhance the value rally, it had already started before this point.

With the renewed underperformance of value since the beginning of the year, Romahi expects another normalisation to take place at some point as growth stocks become increasingly overextended.

He says: “The value spike should be seen in a medium-term context, in which value as a factor has underperformed since April 2014. The value rally over the second half of last year was somewhat anomalous in that regard and about two-thirds of its gains have been given back year-to-date.”

Value performance this year has been less impressive, largely thanks to the influence of the US technology sector.

US technology did very well, which value doesn’t particularly like (as tech stocks tend to produce small earnings but have high valuations). Mega-cap companies in general have performed fairly well and value also tends to steer away from them because mega-caps can be indicative of stretched valuations. Valuations can be perfectly justifiable – but as was the case with the dotcom bubble, they may simply indicate high valuations.

Aniket Das, investment strategist at Legal & General Investment Management, says: “The situation is not as extreme as in the year 2000. We are not in the same position, but there is a similar theme. Will the US tech sector live up to those valuations or will it go the same way as 1999/2000?”

Another qualification comes from Manuela Sperandeo of BlackRock, who rejects the suggestion that value has gone out of fashion.

“Looking at history, it does suffer periods of underperformance. True, year-to-date it hasn’t had a great year but looking at one year until the end of August, it did have a good year.”

Sperandeo points out that the MSCI World Enhanced Value Index has outperformed the broad market by more than 3%. Over the 12 months from June 30, 2016, the index’s performance came in at 22.4%; the broad market’s was 18.2% .

Sperandeo says this was thanks to a combination of market conditions, such as a reflationary market environment that is one of strong economic growth (which tends to support the performance of value stocks). Compelling valuations were another influence. Technical considerations such as dispersion, which measures how stocks are different to each other, also supported value.

Value traps
As is to be expected from a factor given to bursts of activity after periods of underperformance, value is not without its pitfalls. Value traps are the most feared of these.

Value traps are sectors that appear undervalued when prices are falling for good reasons. Justly feared by fund managers, they are very costly.

So, how should one treat value – this frisky number with its hint of danger?

Chris Mellor says that there are two approaches: either timing a trade, which is difficult, or adopting a long-term buy-and-hold approach and waiting. He would advocate not focusing on one particular factor but using an efficient multi-factor approach.

Mellor says the Powershares research team’s view is that the market will grind higher. It doesn’t look like central banks will be aggressively changing policy, and value doesn’t look like bouncing back until there’s another correction.

The team took a positive line on value until the end of the first quarter of 2017 but turned more neutral during the second quarter as some indicators became more muted.

Mellor says: “Looking forward to Q3, we have moved to moderately underweight on value because we observe poor strength in the way value performed recently. We think potential deceleration in economic growth could warrant going underweight.”

Paris-based Ossiam is a proponent of using the ‘cyclically adjusted price to earnings (Cape) matrix’ to assess the valuation of a sector. It uses Cape and historic Cape.

Carmine De Franco, quantitative analyst at Ossiam, says: “Cape is very long-term oriented, it is a stable, robust measure which smooths market cycles and bumps. You can always have sectors more expensive than others but if you use Cape to choose cheap sectors, you will end up always choosing the same sectors.”

Ossiam chooses the five undervalued sectors and excludes the one with the worst momentum, a standard partner to value in value investing.

De Franco believes other value strategies are very similar and highly correlated to one other.

“In terms of how it behaves, it has been a frank success,” he says. “We have collected $1.2 billion over two years. I don’t know many strategies which have beaten the S&P 500 since 2009, but this one has.”

©2017 funds europe