Understanding the Value Factor

This is Part 3 in a series about smart beta ETFs. See below for links to other posts in the series. In this installment, we look at the value factor: the idea that stocks whose prices are low relative to their fundamentals should deliver superior returns.

 

The roots of value investing go back to 1934, the year Columbia finance professors Benjamin Graham and David Dodd published Security Analysis, a biblical volume that is still studied today. Graham and Dodd outlined a strategy for identifying stocks trading for less than their intrinsic value, though they did not frame their work in the context of market-beating returns. That notion came much later, when academics began testing ideas about market efficiency.

In the 1970s and 1980s, a growing body of evidence began to show stocks classified as “cheap” delivered higher returns, regardless of their beta—that is, even if they were not more volatile than the overall market. Sanjoy Basu published a 1977 paper arguing that the performance of stocks was consistently related to their price-to-earnings (P/E) ratios. Another important paper in 1985 found a similar relationship between stocks with low price-to-book (P/B) values and argued this was “pervasive evidence of market inefficiency.”

Many subsequent studies supported the idea that it is possible to identify undervalued stocks by comparing market prices to the company’s fundamentals. These came to be known as value stocks—as opposed to growth stocks, whose earnings are expected to increase at an above-average rate.

Building on these earlier studies, Kenneth French and Eugene Fama published a landmark 1992 paper that analyzed stock returns from 1963 to 1990 and confirmed the “value premium.” Significantly, they found that a low price-to-book ratio was the best predictor of this excess return, and today this is the academic definition of the value factor. In practice, however, many investment strategies try to capture the value premium by screening for stocks with low prices relative to earnings, cash flow, dividend yield, or some combination of these.

Why have value stocks outperformed?

Everyone loves a bargain, so it might seem obvious that underpriced stocks should have higher expected returns. But the real question is why it’s possible to identify value stocks in advance. In an efficient market, mispricings should be quickly identified and exploited, after which they should disappear. Yet the value premium seems to persist, and no one knows exactly why.

Some have suggested that value companies are inherently riskier. Compared with growth companies they have more uncertain earnings, higher debt levels, and are less flexible and slower to adapt to changes in the economy. Perhaps the value premium is simply compensation for these additional risks.

Others have offered behavioural explanations. Many value stocks look cheap because they have performed poorly in the recent past, which scares off investors who dwell on short-term returns. Often value companies seem boring (think utilities and banks) compared with the headline-grabbing growth companies with sexy new products and services. Perhaps investors overpay for that excitement.

What the critics say

Just as the economy goes through cycles, value and growth often take turns outperforming. John Bogle, founder of Vanguard, has argued that “neither strategy—growth or value—has an inherent long-term edge” and “there is no reason to expect either style to outpace the other over time.” Even Warren Buffett—touted as the greatest value investors of all time—has said, “Market commentators and investment managers who glibly refer to ‘growth’ and ‘value’ styles as contrasting approaches to investment are displaying their ignorance, not their sophistication. Growth is simply a component—usually a plus, sometimes a minus—in the value equation.”

It can take extraordinary patience for value investors to get through the inevitable rough patches. Growth stocks can outperform for long periods—in the US, value stocks lagged significantly throughout the 1990s. Even over the 10 years ending August 31, growth outperformed value significantly in the US (9.1% for the Russell 1000 Growth index versus 6.1% for the Russell 1000 Value, in USD) and international markets (5% for the MSCI EAFE Growth and 2.7% for the MSCI EAFE Value, in Canadian dollars).

Moreover, value investing strategies can be challenging to implement. They have traditionally involved analyzing and selecting individual stocks, which is notoriously difficult. Even if you can reliably identify bargains everyone else has somehow overlooked, it’s hard to pull the trigger and sell once the market recognizes the stock’s true value.

Experienced investors are also well aware of value traps. When a stock’s price has declined recently, it could be an opportunity to buy a solid company at a bargain price. But the low price might simply reflect that the company isn’t worth very much and may never recover.

How to access the value factor with ETFs

For Canadian investors seeking exposure to the value factor, there are several ETF options. They highlight the fact that “value” can be defined in many ways. While broad-market ETFs from different providers are more or less interchangeable, the same isn’t true for value ETFs.

  • The iShares Canadian Value (XCV) tracks an index that screens companies according to six measures, including trailing and projected earnings, book value and dividend yield. The fund holds 55 companies and weights them by market cap, so it is heavily skewed to the big banks.
    .
  • The First Asset Morningstar Canada Value (FXM) uses a different methodology that ignores yield and includes earnings revisions. It holds just 30 stocks—the Big Five banks are not among them—and weights them all equally.

Value ETFs in the US, not surprisingly, are more broadly diversified. Again, the methodologies differ, so it’s worth making an effort to understand what you’re buying.

For international equities, consider the iShares Edge MSCI International Value Factor (IVLU), which holds 260-odd stocks selected according to the same strategy as VLUE, or the older and larger iShares MSCI EAFE Value (EFV).

Vanguard Canada’s new family of smart beta ETFs includes the Vanguard Global Value Factor ETF (VVL), which holds stocks from developed countries in proportion with their global market cap. This is an actively managed fund, but it uses a rules-based methodology that focuses on low price relative to book value, forward earnings and cash flow.

Finally, one might also classify the family of fundamental indexes as value strategies. Created more than a decade ago by Research Affiliates, they weight companies according to book value, cash flow, dividends and sales, which has led some to call them value strategies in disguise. (A similar argument can be made for dividend ETFs.) In Canada, ETFs tracking fundamental indexes are available from both iShares and PowerShares for Canadian, US and international equities.

 

Other posts in this series:

Smart Beta ETFs: Your Complete Guide

A Brief History of Smart Beta

 

17 Responses to Understanding the Value Factor

  1. Park September 5, 2016 at 8:38 am #

    Compared to an index fund, value ETFs will have greater turnover. In a Canadian listed ETF, that means increased cap gains tax. But that’s not necessarily true for US listed ETFs. A US listed ETF can use tax lots to minimize capital gains. Such an ability can markedly decrease realized capital gains that you pay tax on. For example, the ETF RZV had an annual turnover rate of 52% as of Oct 31/15. Since its inception in 2006, it has never paid a capital gains distribution, despite having an annual return of 5.30% since the start.

    There are Canadian wrap counterparts of US listed ETFs. Can they also take advantage of tax lots, unlike fully Canadian ETFs?

  2. Aslam September 5, 2016 at 9:35 am #

    Are low value etfs such bmo low value etf can be considered a value factor?

  3. Canadian Couch Potato September 5, 2016 at 10:43 am #

    @Park: This is a great point. US-listed ETFs so seem to be much better at keeping capital gains distributions to a muck lower level. If a Canadian-listed ETF wraps a US-listed ETFs it can take advantage of some of those same benefits, but the Canadian fund can still incur gains and losses if it buys and sells units of its underlying holdings. This might happen during an index change, for example. They can also distribute gains if they add currency hedging.

    @Aslam: BMO’s ETFs are low volatility, not low value. These will be discussed in a later post.

  4. Park September 5, 2016 at 10:59 am #

    This is getting off topic, but I think it’s important. US domiciled ETFs can take advantage of tax lots to minimize capital gains distributions. Truly Canadian domiciled ETFs can’t. A Canadian investing in a US domiciled ETF may not be able to recover foreign dividend withholding taxes, but might be able to in a truly Canadian domiciled ETF. MIght the decreased capital gains distributions of the US domiciled ETF outweigh the ability to recover foreign withholding tax in a truly Canadian domiciled ETF?

  5. Canadian Couch Potato September 5, 2016 at 11:26 am #

    @Park: Definitely off topic, as this has no relevance to value ETFs, so I will leave it here: the problem is there is no way to compare the effect of foreign withholding taxes and distributed capital gains, as the latter can never be known in advance.

  6. Rob September 6, 2016 at 11:55 am #

    Upsetting to see Vanguard take an active management approach although (essentially what smart beta ETF investing is minus the rules-based methodology). For investors looking to capture the potential value premium at a relatively low cost in a simple single ETF solution, this would have been ideal.

  7. Branko September 6, 2016 at 12:52 pm #

    Thanks for this, Dan. Are you going to be looking into factor combinations? From all that I read, I thought that standard thinking was that small-value premium was higher than premiums for small or value factors individually, and was potentially worth pursuing whereas the other two may not be.

    Speaking of which, for those looking for small-value international ETFs, pickings are quite slim. I found WisdomTree’s DGS and DLS to be reasonable approximations for that group. Any other international “dividend” ETF may be as well.

  8. Canadian Couch Potato September 6, 2016 at 1:36 pm #

    @Branko: I will be looking at some factor combinations later in the series. As you say, one of the perpetual challenges in factor investing is that it can be difficult to find products that give you the exposure you want.

  9. Geoffrey B September 6, 2016 at 3:23 pm #

    So is the conclusion here pro value factor (i.e. allocate some portion to value ETFs) or to just stick to broad market indexes (I.e. funds where you can reap benefits of both value and growth).

    I understand that it can take long periods of time until factors begin to kick in, although back tests have shown a long term benefit towards value. As a long hold strategy, is it wise to invest this way since factors may cease to persist over time or would you recommend allocating a small proportion to value or other factors?

    As a side note, I’m really enjoying this series so far!

  10. Canadian Couch Potato September 6, 2016 at 4:34 pm #

    @Geoffrey: No conclusions yet. At this point I just want to explain the factors in detail. I’ll offer my own opinions and recommendations later in the series.

  11. jamie September 6, 2016 at 7:25 pm #

    A great series Dan. Do you have time to elaborate a little on Warren Buffet’s statement above?
    Thanks as always!
    JQ

  12. Canadian Couch Potato September 7, 2016 at 8:19 am #

    @Jamie: That quote is from the Berkshire Hathaway shareholder letter in 2000. Here’s the sentence that precedes it: “Common yardsticks such as dividend yield, the ratio of price to earnings or to book value, and even growth rates have nothing to do with valuation except to the extent they provide clues to the amount and timing of cash flows into and from the business.” My interpretation is that Buffet is calling for a more holistic approach to analyzing companies, rather than simply relying on a few well-known metrics. My sense is that for him, it’s about finding a good company at a good price, whether that happens to be a “value stock” or a “growth stock.”

  13. Gerry P September 8, 2016 at 10:36 pm #

    This is not strictly about the value factor, but is about strategic beta; I was reminded of your April Fools’ posting celebrating a fictional uber-smart beta factor ETF from “Dr. Molto Fattore” when I went to Morningstar’s website this week. On it, they laud a Goldman Sachs multi-factor strategic beta ETF which selects for equal parts value, momentum, quality and low volatility: (ta-da!) the Goldman Sachs ActiveBeta U.S. Large Cap Equity ETF. And I had thought you were making it all up! http://news.morningstar.com/cover/videocenter.aspx?id=768816

  14. Nicolas September 10, 2016 at 8:15 am #

    Hi,

    You should tag Part 1, etc.. in the title, it’s difficult to find path 🙂

    Anyway, very interesting..

    Nico from Luxembourg

  15. Audrey September 10, 2016 at 7:55 pm #

    “In the US, value stocks lagged significantly throughout the 1990s. Even over the 10 years ending August 31, growth outperformed value significantly in the US …”

    In other words, value stocks have underperformed during most of the period since the publication of the Fama-French paper. Is it possible that the value premium has disappeared in the same way as the January effect — because a market inefficiency was brought to the broad attention of investors who then exploited it into non-existence?

  16. Canadian Couch Potato September 11, 2016 at 7:58 am #

    @Audrey: Remember that Fama and French were not the first to identify the value premium: it was known earlier than the 1990s. They just incorporated it into a model.

    Staunch believers in efficient markets do indeed argue that the value premium should be expected to disappear once it is identified, assuming that the reasons value stocks outperformed in the past was behavioural. But if you believe that value stocks are genuinely more risky, then investors are just being compensated for this additional risk, and there is no way to arbitrage it away. Personally I don’t think the value premium has disappeared, but it is definitely fleeting and it requires a lot of long-term discipline if you’re going to be rewarded.

  17. Kenny Gullette September 11, 2016 at 11:36 pm #

    When the value factor “disappears” it is actually just hibernating and becoming even cheaper. I believe value is now as cheap as it has been in over a decade. The lowest 20% of P/E, book value has the widest range from the highest book value, P/E that it has had in a long time.
    Just when people write something off is often the best time to buy.

Leave a Reply