Giving a Boost to Value Performance—with a Little Factor Awareness (and Luck)
In a piece headlined “Hot-Stock Rally Tests the Patience of a Choosy Lot: Value Investors,” The Wall Street Journal on August 7 detailed the poor performance of Value funds and indices relative to their Growth counterparts that has been plaguing Value managers for quite some time.
There are a few benefits to having been in the equity analysis business for a (long) while. One is having the firm knowledge that investment styles can go in cycles. (Although I have to admit that “longtime value investor” Jeremy Grantham’s quote “This time seems very, very different” gave me pause…) The cycles may last longer and go deeper than seems possible, but they do eventually reverse -- often when investors are just about to throw in the towel. I remember an article in the same newspaper during the late 90’s Internet boom that told the story of an individual investor sending a letter to a well-known Value fund manager who prior to the boom had an impeccable record, saying something like “let me know where you went to college because I DO NOT want to send my children there”. Note that the Internet bust was followed by about seven years of Value outperformance.
This time around, as defined by the respective Russell 1000 indices, Value has underperformed Growth over the past 10 years to the tune of almost 3% annually (although it had a strong 2016), and the shortfall has accelerated sharply this year with the strength of the so-called FAANG stocks driving the Growth index.
To dig a little deeper into this topic we ran factor-based attribution for the Russell 1000 Value index versus the Russell 1000 Growth index for the 10 years ended July 31, 2017. The results showed that Value’s underweight in Information Technology and overweights in Energy and Financials hurt returns a bit (and were largely offset by profitable bets in other sectors), but the biggest drivers of the shortfall were (1) negative exposure to Axioma’s Profitability factor, which led to about half the underperformance and (2) stock specific sources that drove the other half.
If the market decides to reward richly-valued companies with continued price gains there may not be much a Value manager can do about that, but these results suggest that Value managers who expect this cycle to continue have at least one option they may not have considered: they can reduce their negative exposure to Profitability (in other words, tilt toward relatively more profitable companies). That wouldn’t have completely erased the shortfall, but it would have helped. And those who do not want to change their process may take comfort in the fact that the popularity of high flying stocks never lasts forever (although it usually lasts longer than anyone expected).
I can state with certainty that this cycle will revert. What I do not know is when or what will trigger it.