PMC Weekly Review – October 26, 2018
Investors continuously look for an edge, seeking to maximize returns relative to risks. Favored strategies change cyclically, or trend during certain market environments, but one has always been in style: value investing. Value investors attempt to find underpriced stocks relative to fundamentals, and often examine valuation ratios or use a discounted cash flow model to uncover them. Despite the popularity of the Efficient Market Hypothesis, purists argued that mispricing ran counter to its underlying theory that asset prices fully reflect all available information, and the only way an investor could receive a higher return would be to take on more risk.
Risks themselves tend to fall into two camps: unsystematic and systematic. Unsystematic, or undiversifiable risks, pertain to the uncertainty of investing in one company, and investors can manage them by avoiding putting all their eggs in one basket. Systematic risks, however, are inherent to investing and cannot be diversified away, as they encompass market uncertainties, such as interest rates, volatility, and business cycles. Beta, the measure of volatility of an asset compared to the market, is used as a proxy for systematic risk.
Prior to the 1980s, researchers and academics thought beta, or the magnitude of a stock’s move in relation to the overall market, was the only explanatory variable of a stock’s return. Based on the Capital Asset Pricing Model (or CAPM for short), the individual risk premium of a stock equaled the market premium times the stock’s beta. In essence, a beta of 1.1, for example, meant that CAPM would predict greater out- or underperformance of the market, as the stock had a higher degree of volatility relative to the market.
Nobel Prize winner Eugene Fama and esteemed professor Kenneth French meticulously studied stock returns and sought to develop a model that more fully explained their performance. Although Fama and French ultimately determined that five factors characterized the bulk of stock performance, their research showed that one of the most important and, since their original paper, one of the most studied and used by investors and money managers alike, is the value factor. The value factor is the tendency for stocks that are less expensive, according to a fundamental dimension (such as book-to-market or earnings-to-price ratios), to outperform more expensive ones. Their seminal 1992 paper, “The Cross Section of Expected Stock Returns,” proved just that. It also examined the size effect, or the tendency for smaller companies to outperform larger ones, and concluded that value was an even stronger determinant of stock returns. They went as far as to state, “Moreover, although the size effect has attracted more attention, book to market equity has a consistently stronger role in average returns.” It seems that famous value investors Benjamin Graham and Warren Buffett may have been on to something, whether or not they purposefully leveraged the statistical evidence.
Recently, the value factor has struggled over the past few years, handily becoming the worst- performing factor among domestic equities (Source: QRG). In the domestic equity segment, the factor is down 7.7% on a one-year basis (as of September 30, 2018). Even over a five-year timeframe, it has underperformed factors such as quality and momentum, and is in negative territory.
This poses a challenge to many active fund managers, several of whom prefer companies with attractive valuations. However, a couple of indicators suggest that the pain for value soon may be over. One indicator, the value spread, looks at the difference between cheap and expensive securities—historically, the wider the spread, the stronger the expected returns for value strategies. The spread has widened over the past few years, yet not to levels experienced at the peak of the tech bubble in 2000. Additionally, price-to-earnings ratios for value stocks are trading at a discount relative to their 15-year historical average, whereas those of growth stocks are trading at a premium. Lastly, there has been a significant disparity of performance in growth and value indices, and such wide disparities tend to ebb and flow over time. For example, as of September 30, the Russell 3000 Growth Index is up 16.99% year to date, while the Russell 3000 Value Index is up a relatively paltry 4.17%, a difference of more than 1250 basis points in favor of growth stocks. All these facts may point to better days for value, but exactly when it will be back in vogue is anyone’s guess.
The information, analysis, and opinions expressed herein are for general and educational purposes only. Nothing contained in this weekly review is intended to constitute legal, tax, accounting, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. All investments carry a certain risk, and there is no assurance that an investment will provide positive performance over any period of time. An investor may experience loss of principal. Investment decisions should always be made based on the investor’s specific financial needs and objectives, goals, time horizon, and risk tolerance. The asset classes and/or investment strategies described may not be suitable for all investors and investors should consult with an investment advisor to determine the appropriate investment strategy. Past performance is not indicative of future results.
Information obtained from third party sources are believed to be reliable but not guaranteed. Envestnet|PMC™ makes no representation regarding the accuracy or completeness of information provided herein. All opinions and views constitute our judgments as of the date of writing and are subject to change at any time without notice.
Investments in smaller companies carry greater risk than is customarily associated with larger companies for various reasons such as volatility of earnings and prospects, higher failure rates, and limited markets, product lines or financial resources. Investing overseas involves special risks, including the volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, and relatively illiquid markets. Income (bond) securities are subject to interest rate risk, which is the risk that debt securities in a portfolio will decline in value because of increases in market interest rates. Exchange Traded Funds (ETFs) are subject to risks similar to those of stocks, such as market risk. Investing in ETFs may bear indirect fees and expenses charged by ETFs in addition to its direct fees and expenses, as well as indirectly bearing the principal risks of those ETFs. ETFs may trade at a discount to their net asset value and are subject to the market fluctuations of their underlying investments. Investing in commodities can be volatile and can suffer from periods of prolonged decline in value and may not be suitable for all investors. Index Performance is presented for illustrative purposes only and does not represent the performance of any specific investment product or portfolio. An investment cannot be made directly into an index.
Alternative Investments may have complex terms and features that are not easily understood and are not suitable for all investors. You should conduct your own due diligence to ensure you understand the features of the product before investing. Alternative investment strategies may employ a variety of hedging techniques and non-traditional instruments such as inverse and leveraged products. Certain hedging techniques include matched combinations that neutralize or offset individual risks such as merger arbitrage, long/short equity, convertible bond arbitrage and fixed-income arbitrage. Leveraged products are those that employ financial derivatives and debt to try to achieve a multiple (for example two or three times) of the return or inverse return of a stated index or benchmark over the course of a single day. Inverse products utilize short selling, derivatives trading, and other leveraged investment techniques, such as futures trading to achieve their objectives, mainly to track the inverse of their benchmarks. As with all investments, there is no assurance that any investment strategies will achieve their objectives or protect against losses.
Neither Envestnet, Envestnet|PMC™ nor its representatives render tax, accounting or legal advice. Any tax statements contained herein are not intended or written to be used, and cannot be used, for the purpose of avoiding U.S. federal, state, or local tax penalties. Taxpayers should always seek advice based on their own particular circumstances from an independent tax advisor.
© 2018 Envestnet. All rights reserved.