During the past bullish decade led by booming mega-cap growth companies, value-style stocks have chugged along in the slow lane of the equity markets. The bargain-hunting school of investing, whose heroes include the likes of Benjamin Graham and Warren Buffett, has experienced a prolonged slump. Rather than holding a value-style portfolio, most investors would have been better off investing passively in the broad market indexes over the past 10 years.
In comparing value stocks to their growth counterparts, the performance gap is even wider. Consider, for instance, the Russell 1000 Growth Index versus the Russell 1000 Value Index. Over the 10 years ended Dec. 31, 2019, as measured in U.S. dollars, the U.S. growth index returned an annualized 15.2%, with the value index trailing badly at 11.8%. Growth showed even wider margins of outperformance over value during the past one, three and five years.
There have been longer droughts for value in the nearly 100-year history of analysis of this factor, says Hail Yang, vice president, product strategy, with Toronto-based BlackRock Asset Management Canada Ltd. “But certainly, it’s been probably in the top three or top five in terms of longer periods of underperformance.”
Style factors tend to perform differently at different parts of the market cycle. Historically, value has tended to do well in the early stages of a bull market. This helps explain why value is lagging now. “It hasn’t really had that market environment where you’d expect it to shine, and so we’ve seen an extended period of value underperformance,” Yang says. “But that doesn’t detract from our conviction that value is a rewarded factor over time.”
Value investing is a somewhat higher-risk strategy than some investors may think, says Chris Heakes, director and portfolio manager, ETFs, with Toronto-based BMO Asset Management Inc. He noted that BMO’s suite of three ETFs based on MSCI value indexes typically have betas in the 1.1 to 1.2 range. (A broad market index, by definition, has a beta of 1.) When markets recover after a selloff, value portfolios “tend to outperform very well,” says Heakes, as they did in the post-crash period of 2009. “We expect a rotation back into value at some point.”
Among Canadian-listed ETFs, the purest and most globally diversified value strategy is that of Vanguard Global Value Factor ETF. Investing in developed markets, it ranks large, mid-cap and small-cap stocks in each of three broad regions: North America, Europe and Pacific. The scores are derived from three value metrics: price to book value, forward price to earnings (P/E) and price to operating cash flow. The ETF’s more than 1,000 stock holdings virtually eliminate the impact of any one individual stock.
Purity of style and the elimination of market-cap bias has yet to pay off for Vanguard’s value ETF. Along with lagging the broad global equity market, its returns have been much lower than those of the three other factor-style Vanguard ETFs that also launched in June 2016.
Unlike at Vanguard, a bias in favour of large companies is evident in the value ETFs offered by BMO and BlackRock’s iShares. BMO MSCI Canada Value Index ETF, BMO MSCI USA Value Index ETF and BMO MSCI EAFE Value Index ETF each employ scoring systems based on forward P/E, price to book and enterprise value to operating cash flow. The stock weightings are based on the value scores within sectors, multiplied by market capitalization.
As a result, the sector weightings in the BMO ETFs tend to be fairly close to those of the broad market indexes. “What we’re trying to do is have something that looks somewhat like the broad index but tilted within those sectors to the more value-oriented stocks,” says Heakes. “If you just do value without some thought to sector it could really load up on certain sectors.” This sector-neutral MSCI methodology, which is also employed in iShares Edge MSCI USA Value Factor Index ETF, imposes a cap of 10% per stock. BMO’s EAFE strategy, meanwhile, seeks to maintain neutrality between geographic regions.
Since their launch in October 2017, the three BMO ETFs have generally been below-average performers in keeping with the prevailing trend for value mandates. Nonetheless, says Heakes, having an allocation to value stocks can be beneficial for a retail investor. He cautions against investing exclusively in one particular style, such as U.S. large-cap growth, for example, which has done very well. A value ETF, says Heakes, “will offer some diversification within equities.”
In building the portfolio for iShares Canadian Value Index ETF, Canadian stocks are ranked according to a Dow Jones methodology that factors in projected price-earnings ratios, price to book and trailing dividend yield, along with three growth metrics. Stocks that make it into the value index are weighted according to market capitalization, subject to a 10% cap per stock. Launched in November 2006, the iShares ETF has been a below-average performer over the past 10 years.
Though the P/E ratio is a common metric for value-factor ETFs, strategies differ as to whether to use historical P/Es, which are based on past actual earnings, as opposed to forward P/Es, which rely on earnings projections. BlackRock’s Yang says the forward P/E helps avoid value traps — companies that are trading at cheap prices because of deteriorating earnings. “You’re trying to avoid the companies that are actually basically going down because they should be going down.”
By contrast, CI First Asset’s value-style ETFs employ trailing P/E ratios as part of the selection process. But its methodology addresses the risk of value traps by screening for positive earnings revisions by the analyst community. This momentum-style metric is intended to complement the value criteria, which also include price to book, price to sales and price to cash flow.
The three portfolios are equally weighted. There are sector caps for CI First Asset Morningstar Canada Value Index ETF and CI First Asset Morningstar US Value Index ETF, and regional constraints for CI First Asset Morningstar International Value Index ETF.
“By screening only for traditional value, you might find a lot of companies in industries and sectors that have been depleted, [and are] therefore worthy of low valuations,” says Peter Tomiuk, senior vice-president, ETF strategy, with CI First Asset, a division of Toronto-based CI Investments Inc. With companies that have growing earnings, along with low valuations, investors can profit if those earnings projections are realized, Tomiuk adds. “That provides a very good opportunity for alpha generation.”
In seeking alpha, screening for positive earnings revisions hasn’t been enough for the CI First Asset ETFs to overcome the market’s prolonged bias against value stocks. Over the past five years ended Jan. 31, 2020, the Canadian and U.S. ETF ranked in the bottom quartile of their respective categories, and the international equity ETF was a below-average performer.
However, Tomiuk says that over longer periods for the underlying Morningstar indexes — not the real-life history of the ETFs — each of the three strategies has outperformed broad market indexes in terms of both absolute returns and risk-adjusted returns. The best of the three was the Canadian value index, which, during a nine-year period to the end of 2019, had a “capture” rate of 110% of positive returns, while holding its capture rate of negative returns to only 66%.
“Any factor strategies fall in and out of favour regularly. I think it’s well known that value has been out of favour for quite a while,” says Tomiuk. “But if you take a look through an entire economic cycle, usually the value strategies have done quite well.”