In 50 years of factor investing, there have been a series of love/hate phases with regard to the use of factors in selecting stocks for portfolios. At present, 2019-2020 seems likely to go down in history as a period of aversion, much like 2009-2011 and 1998-2000. These are the periods when most of the conventional factor combinations used by portfolio managers did not perform.
There are good reasons to expect the recent underperformance reported by a number of equity quantitative managers to be temporary. While there have been claims that this time is different, this was also the case after previous episodes of underperformance. Indeed, this time round, predominantly the value factor accounts for much of the poor performance. The quality factor has delivered strong performance; momentum factors also delivered good performance while the performance of low risk was mixed.
Listen to Raul Leote de Carvalho, deputy head of our quantitative research group, talking about performance of the value, quality, momentum and low-volatility factors:
It is not surprising that investors relying on a simplistic value strategy feel disappointed after such a long period of under-performance.
Investors interested in value investing should rely on multiple dimensions of fundamental value, from diverse accounting perspectives, even taking into consideration all the financing resources of a company. Long-term cash flows and the capacity to generate profits should be the ultimate measures of fundamental value. When constructing a value strategy, it is also important to avoid sector biases and exposure to market risk (beta) as well as controlling for the overall level of risk.
All of these important features shall significantly enhance value strategies.
In this video, Benoit Bellone, senior quantitative researcher, explains why the choice of value factor construction is crucial:
The recent under-performance of value stocks against expensive stocks is a result of prices diverging from fundamental values. In most regions and sectors, equity prices are now as far from fundamental values as they were at the peak of the tech bubble in 2000. The COVID crisis of 2020 seems to have amplified a flight-to-expensive-growth that has kept accelerating since 2018. During this phase, investors seemed eager to buy growth stocks at ever-higher valuations, adding more to the pain inflicted on value investors.
We do not see much room for this trend to continue. We believe that expecting prices of stocks to converge towards fundamental values remains a sensible investment philosophy and the likely trend in the coming years.
“A secular flight to growth stocks” – In this video Benoit Bellone talks about the most recent bear market in value stocks
In 2020, value spreads reached levels last seen at the peak of the tech bubble in 2000. In our view, such spreads in valuations are neither justified nor sustainable. Value stocks are simply as cheap, relatively speaking, as they have ever been while the contrary applies to expensive stocks.
While irrational exuberance may continue, a compression of value spreads over the next few years is, in our opinion, the more likely outcome.
With value spreads everywhere now at, or around the extreme high levels last seen at the peak of the tech bubble, we expect a period of value spread compression in coming years. Capitulating on the value style right now might turn out to be a very costly experience
Compression of the value spread should be positive for both value and small-capitalisation stocks as well as diversified multi-factor investing approaches.
Benoit Bellone addresses the question of whether investors can afford to do without the value factor in their equity allocation:
Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice.
The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.
Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).
Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.