At the beginning of the year, I outlined my predictions for smart beta strategies for 2017. My colleague Matt Tucker, iShares Head of Fixed Income Strategy, and I had a good chat about fixed income factors, one of the predictions, earlier this month. Today I’d like to take a deeper dive into another: The revival of risk-seeking factors, namely value.
Some background first
The rise of smart beta over the past several years has largely coincided with a low growth, defensive market environment. Investors sought after minimum volatility strategies for possible downside protection in times of crisis. But as the global economy improved and recessionary fears gave way to a more decidedly pro-growth, reflationary theme in markets last summer, many investors became less defensive. Securities with greater potential for capital appreciation, including value strategies—the most beaten down in past years—returned to favor. And for a good reason: value has tended to do well when market trends reverse (source: Ang, Andrew. Asset Management: A Systematic Approach to Factor Investing. Oxford University Press. 2014).
What is value?
Value investing is about finding bargains—companies with low prices relative to their peers. Over the long run, companies with low prices relative to fundamentals have tended to outperform the market (source: J. Lakonishok, A. Shleifer, R. Vishny. Contrarian Investment, Extrapolation, and Risk. Journal of Finance, 1994). This makes value an investment factor—a broad, historically rewarded driver of returns.
From an economic perspective, many value firms are in traditional businesses such as manufacturing, industrial production and financial services. These companies can’t easily change practices because they have specific business models, high levels of specialized equipment, or production processes that are not easily convertible for other purposes. While they have tended to lag in slow economic periods, they may capture the uplift more efficiently during times of booming economic growth.
Traditional value strategies have been around and practiced for decades, but not all value strategies are made alike. Careful examination into how value strategies are measured could yield vast differences in desired outcome.
Measurement matters: optimal value capture involves multiple metrics
A stock’s price alone is not a reliable measure of value. Rather, value strategies look at a company’s stock price relative to its intrinsic value, which takes into account one or more fundamental measures. Many investors focus on certain ratios, such as a company’s stock price relative to its book value, or stock price relative to expected earnings.
Individual valuation ratios have various limitations, however, so there are benefits to using more than one. It’s important to look at a company as a whole—its enterprise value. A company may appear cheap in relation to its outstanding stock, but it may be expensive when considering the debt it has taken on. Additionally, a company’s earnings may include short-term events that could reverse, or they may reflect temporary financial transactions compared to more permanent operational changes. Comparing a company’s enterprise value to its cash flow from operating activities can help us better understand the strength of a company’s operations relative to its outstanding stock and debt. A more robust and lasting measure of value uses all three valuation estimates: price-to-book ratio, forward-looking price-to-earnings ratio, and enterprise value-to-cash flow from operating activities.
A smart way to capture value with smart beta
Value exposures have long been part of well-balanced portfolios. However, as with every industry, principles of portfolio construction and asset management have evolved rapidly through technological advancement. We are seeing a new wave of low-cost, alternative benchmarks and beta exposures come to the fore. These strategies utilize many of the screening techniques of active managers, are rooted in decades of academic research, and may serve as even better proxies for the low-cost alternative to active management than traditional market cap weighted value benchmarks. So-called factor indexes (and the beta strategies that follow them), like the MSCI USA Enhanced Value Index and iShares Edge MSCI USA Value Factor ETF (VLUE), screen for securities using multiple metrics, and weight them not by market capitalization, but by their exposure to value price multiples. This allows for greater emphasis on valuation and therefore greater potential for exposure to “value” as a driver of returns.
Join BlackRock and industry thought leaders for our 2017 virtual conference, “Factors: The Next Era in Portfolio Construction,” on Tuesday, May 9th.