There Are Many Ways to be a Value Investor
Value investing’s strong long-term track record makes a compelling argument in favor of cheap over expensive.
|A version of this article previously appeared in the February 2021 issue of Morningstar ETFInvestor. Click here to download a complimentary copy.|
The stock market provides investors with a powerful tool. According to the efficient-market hypothesis, investors’ collective buying and selling should push stock prices close to companies’ true underlying value. But pooling those opinions together is an imperfect exercise, with bubbles and crashes throughout history proclaiming its flaws.
The market’s imperfect nature creates opportunities for those with dissenting views. Moving away from trendy stocks pushes an investor’s portfolio toward the less-loved and mundane—types of stocks that typically trade at lower valuations. That isn’t such a bad thing. Despite a challenging decade, value investing’s strong long-term track record makes a compelling argument in favor of cheap over expensive. Done well, dissenting views expressed through value investing have the potential to improve long-term performance. There are a number of approaches that should work well. Some are trivial, others less obvious. And then there are those that amplify risk and should be avoided at all costs.
Going against the grain need not be complicated. The simple act of rebalancing a few broad-market index funds back to a target allocation has a contrarian feel to it, forcing investors to sell what has performed relatively well and buy what has performed relatively poorly. Such actions may move assets away from stocks and toward bonds or take them from richly priced stocks and give them to those trading at lower multiples. Rebalancing can prevent unwanted concentration from taking hold.
A bias toward cheaper stocks is easily observed by comparing the simulated performance of two portfolios. Both started on Dec. 31, 2010, with a 50/50 mix of U.S. and foreign stocks, represented by Vanguard Total Stock Market ETF (VTI) and Vanguard Total International Stock ETF (VXUS), respectively. One portfolio was allowed to run without intervention, while the other rebalanced back to its 50/50 target on the last day of each year.
Exhibit 1 shows the outcome of both strategies. Given the strong performance of the U.S. market over the past decade, the untouched portfolio ended with a lopsided allocation to U.S. stocks, while the rebalanced portfolio kept near its 50/50 target. Those weighting differences drove a wedge between average valuations. The untouched portfolio favored pricier U.S. stocks and ended with a higher price/book ratio than the rebalanced strategy.
The mechanism at work in the rebalanced portfolio relies on forcing an asset’s weight to something other than what its market cap would suggest. It held equal stakes in VTI and VXUS, regardless of how one performed relative to the other. The result was a portfolio that was underweight in expensive (U.S.) stocks and overweight in cheaper (overseas) fare.
That contrarian mechanism is not unique to rebalancing a few low-cost index funds. Exchange-traded funds tracking fundamentally weighted indexes like Schwab Fundamental U.S. Large Company ETF (FNDX), which has a Morningstar Analyst Rating of Silver, have used a similar approach to build stock portfolios. Rather than weight its constituents by market cap, FNDX sizes its positions based on several fundamental metrics, including sales and cash returned to shareholders through dividends and buybacks.
Like the 50/50 simulation, FNDX reinforces its value orientation during its rebalance, moving away from stocks that have grown expensive relative to fundamentals and toward those with the opposite dynamic. Exhibit 2 shows that FNDX’s average price/book ratio has consistently landed below that of the Russell 1000 Index.
Low-volatility strategies are another contrarian approach in the sense that they invest in a basket of relatively stable yet boring companies. Popular but volatile stocks like Tesla (TSLA) won’t make the cut for many of these portfolios. That often leads to a value orientation, though the degree to which low-volatility strategies emphasize stocks trading at lower multiples is less pronounced and less consistent than a fundamentally weighted portfolio like that of FNDX.
Neutral-rated Invesco S&P 500 Low Volatility ETF (SPLV) is one such low-volatility strategy. It holds the 100 least-volatile names in the S&P 500 and weights them by the inverse of their standard deviation over the trailing 12 months, placing greater emphasis on the least-volatile names in its portfolio.
By design, low-volatility funds like SPLV don’t explicitly target stocks with lower valuations. During periods of sustained stable growth, SPLV’s average price/book ratio has tended to match or even exceed that of the broader market. However, it has retreated toward stocks trading at lower valuations when volatility picks up, favoring companies in more-stable sectors like utilities and consumer staples.
Exhibit 3 shows that the average price/book ratio of SPLV’s holdings dipped below that of the overall market in early 2018, when the U.S. market ended a long streak of stable price appreciation. The market’s volatility started to rise at that time, causing SPLV to take refuge in stable utilities like Xcel Energy (XEL) and Duke Energy (DUK), which contributed to its lower price/book ratio.
Contrarian thinking by way of value investing has its limits. At a certain point, the risks of chasing cheap stocks become too great and can seriously compromise long-term performance. In the near term, stocks often have trouble overcoming momentum, or their tendency to continue moving along their recent trajectory.
Negative momentum can be a headache for value investors because it makes timing the bottom in a stock’s price difficult, a situation often referred to as catching a falling knife. It is possible to get lucky reaching for these stocks, buy at or very near their price’s bottom, and capture the ensuing rebound. However, the more likely scenario is that losses will continue, at least for a little while, inflicting further pain on those brave enough to open their hands.
Potentially injurious outcomes aren’t enough to keep some from trying. Direxion Fallen Knives ETF (NIFE) is a contrarian strategy that’s willing to take a few lacerations. It explicitly looks for stocks with negative momentum, or negative price returns over the trailing 12 months. It screens this cohort to find the most financially sound names, those that should be poised for a rebound.
On paper, that proposal sounds great. Who wouldn’t want to buy financially strong companies with cheap price tags? Reality seldom supports that narrative. Negative momentum on its own is a losing strategy. And finding companies with a combination of depressed prices and strong financials is challenging, to say the least. Prices tend to fall for a reason, often anticipating a decline in a company’s fundamentals. So, cheap prices and poor fundamentals often go hand in hand.
NIFE’s portfolio demonstrates that connection. As of January 2021, its price/book ratio was less than half that of the Russell 1000 Index. But its holdings, on average, barely managed to turn a profit over the preceding 12 months.
Despite NIFE’s rather extreme contrarian perspective, it teaches an important lesson. Stocks with depressed prices often have depressed fundamentals or poor growth prospects. Low growth expectations are the reason for their diminutive valuations.
The trick, however, is striking the right balance between compelling valuations and a firm’s ability to continue earning and growing profits. Funds like FNDX and SPLV do a good job of balancing those two competing characteristics. Exhibit 4 shows how their valuations and profitability stack up against NIFE. As contrarian strategies, they’re a better long-term bet. They also offer better diversification and charge lower fees.
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Daniel Sotiroff does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.