October 25, 2014

Value Investing Redux

Believe it or not, I was once a value investor. From an early age I was impressed with the long-run success of such value luminaries as John Neff, Bill Ruane, Walter Schloss, and Max Heine. Being of a contrary temperament, I also liked the idea of buying stocks that were out-of-favor and ignored by the multitudes. Supporting this approach, DeBondt and Thaler (1985) presented evidence that stocks overreact to bad news, and that poor performers over the past 3 to 5 years tend to outperform when moving forward. Value investing seemed to have representative bias going for it, whereby investors overreact to poor performance and project it far into the future while failing to account for long-run mean reversion.

In 1992, Fama and French presented their groundbreaking paper indicating that value and small cap stocks offered up a risk premium to investors. I, along with the rest of the civilized world, readily accepted this idea.

What got me away from value wasn't anything about value itself, but rather was my discovery, after reading a plethora of research papers on momentum, of just how strong momentum is compared with anything else. Looking at relative strength momentum applied to individual stocks showed a higher premium.

What also got me excited about momentum though was my own research showing that momentum can be applied not just across different investment opportunities, but to single investments themselves in the form of trend-following absolute momentum.  Absolute momentum not only enhances returns like relative momentum, but it can also greatly reduce drawdown. As far as I could tell, no other anomaly could do this.

Reinforcing my view were the surprising results about value by Israel and Moskowitz (See my post "Momentum…the Practical Anomaly?"). Working with U.S. equities data back to 1926, the authors found that:

The value premium… is largely concentrated only among small stocks and is insignificant among the largest two quintiles of stocks (largest 40% of NYSE stocks). Our smallest size groupings of stocks contain mostly micro-cap stocks that may be difficult to trade and implement in a real-world portfolio.

Earlier research by Loghran and Houge (2006) also found the value premium to be illusionary.

Research by Das and Rao (2012) showed that large cap value only works in January.  On another front, Chen et al. (2011) proposed an asset pricing model in which investment and profitability are the main explanatory variables, rather than value and size. Fama and French (2014) then expanded their established three-factor model to include investment (expected future changes in book equity) and profitability (expected future net income relative to book assets). When doing so, they concluded that value was redundant.


So did all this put a nail in the coffin of value investing? Not necessarily. Israel and Moskowitz had looked at value using the popular book-to-market ratio. They found similar results using other value measures, such as dividend yield and long-term reversals that had data going back to at least the 1930s. However, these were only singular measures of value.

Dhatt et al. (2001) found that composite measures of value were superior to any individual metric. Moreover, in their book Quantitative Value: A Practitioner's Guide to Automating Intelligent Investment and Eliminating Behavioral Errors, Gray and Carlisle identified a valuation metric based on enterprise multiple, defined as total enterprise value (TEV), divided by earnings before interest, taxes, depreciation, and amortization (EBITDA). Here is a table of valuation metric comparisons by Gray using equal weight portfolios sorted into quintiles. Data is from 1971 through 2010 and excludes micro caps. Perhaps use of the enterprise multiple instead of price-to-book (P/B) could restore confidence in the value premium? The folks at AQR have also tried to improve upon value by incorporating more timely information into the equation.

comparative valuation metrics


Some researchers have found that adding a financial strength or quality metric may improve the risk-adjusted results of value portfolios. Paying attention to these extra factors can help overcome the problem of the "value trap," which happens when stocks remain depressed (and may go bankrupt) because their poor fundamentals warrant it. We should keep in mind though that there is always the potential of overfitting and selection bias when combining factors.

Using global data from 1988 through 2012 and U.S. data from 1963 through 2012, Kozlov and Petajisto (2013) found that going long stocks with high quality earnings (based on high return on equity, high cash flow, and low leverage) and short stocks with low quality earnings gave higher Sharpe ratios than a similar value only strategy. They also found earnings quality to be negatively correlated with value. The best Sharpe ratio came from combining high quality with value, since there were significant diversification benefits.

Using a different approach, Piotroski and So (2012) came up with a multi-factor scoring method (F-Score) to measure a firm's financial strength. This method was positively correlated with profitability and earnings growth. Piotroski and So found that strategies formed jointly on F-Score and value outperformed traditional value only strategies.

Novy-Marx (2012) found he could simplify the quality factor to just gross profitability, defined as revenues minus cost of goods sold, scaled by assets. Novy-Marx (2013) found on U.S. stock data from 1963 through 2012 that profitable firms generated significantly higher returns (0.31% per month) than unprofitable firms, despite having higher price-to-book ratios. Novy-Marx (2012) also found that joint strategies combining value with Piotroski/So's F-Score, Greenblatt's magic formula, or gross profitability outperformed traditional value, with profitability plus value being the strongest combination.

growth of value plus quality


Despite the above potential enhancements to value investing, given the enormous advantages of dual momentum investing, if I were ever to get the urge to do value investing, I would just lie down until the urge went away. But if I were actually going to add a value component to my portfolio, it would need to be calculated on a more robust basis than price-to-book, and it would need to be combined with profitability/quality to mitigate the potential value trap problem. Here is what I might look for in a value fund if I were going to invest in one::

1)    It should combine value with quality and/or profitability screens.
2)    It should determine value based on several value metrics and/or a value metric that incorporates the enterprise multiple.
3)    It should not dilute returns by having too broad a portfolio. In Chapter 6 of my new book, Dual Momentum Investing: An Innovative Strategy for Higher Returns with Lower Risk, I show that many so-called smart beta funds are like closet index funds with modest stylistic tilts. Unfortunately, most value funds are the same. Even though the value effect is more pronounced in the top 10-20% of value rated stocks, most funds dilute this effect by using the top third or top half of value stocks instead of the more profitable top 10-20%.
5)    The expense ratio should be reasonable. (This is true of all investments.)
6)    For taxable accounts, ETFs are preferred over mutual funds and hedge funds. Capital gains usually occur only when you sell your ETF holdings, whereas mutual funds have yearly taxable distributions of capital gains.


If value and quality actually do well together, it is natural to think of actively managed mutual funds when considering investment candidates based on such factors. This is because most active managers use fundamental analysis (which takes into account profitability in the form of financial strength), managerial acumen, competitiveness, quality of earnings, and other judgmental factors besides valuation.

But most active managers lack transparency. This gives them the appearance of possessing proprietary knowledge that may be worth paying a premium to access, but it also means it is often difficult to tell if they meet the first two criteria listed above. Active mangers also charge high fees. The Morningstar average large cap value fund annual expense ratio is 1.16%. Mutual funds also have a drag on their performance because of their reserves that are held for redemption. Also, as mentioned above, these funds are generally not tax efficient.

But there is one mutual fund that may be worth looking at. It is the AQR Core Equity Fund (QCELX).[1]  This fund meets our first two requirements above, since it uses three indicators of profitability along with five indicators of value. For good measure, it adds three momentum indicators. QCELX has an annual expense ratio of 58 basis points. It is also not tax efficient, although AQR has plans for a more tax efficient version of the fund. QCELX currently holds 413 stocks, which is more than 40% of the stocks in its 1000 mid/large cap stock selection universe.[1] Investors are paying a high fee for the index part of this fund.

In the ETF realm, until this past week there was only one fund that qualified using the above criteria. It was the PowerShares Dynamic Large Cap Value ETF (PWV) based on the Intellidex methodology. PWV uses a ranking selection method with four indicators of value and four indicators of growth. They subtract their value from their growth rankings and then select the largest negative scores. This process gives PWV some profitability exposure, according to the research of Bridgeway Capital Management. Bridgeway found that a multi-indicator value approach (adding price/cash flow, price/earnings, and price/sales) provides greater exposure to gross profitability than a portfolio based only on price/book.

To help further with profitability exposure, after doing their basic screens, PWV adds weightings for price momentum, earnings momentum, quality, and management action. PWV selects the top 20% of the largest 250 stocks from a potential universe of 2000. This gives them a focused portfolio of only 50 stocks that PWV rebalances quarterly. (I would prefer that they derived their portfolio of 50 stocks by selecting the top 10% of the largest 500 stocks instead of the top 20% of the 250 largest stocks.) They allocate half their capital to the top 15 ranked stocks, and the other half of their capital is divided among the remaining 35 stocks. Their annual expense ratio is 58 basis points. PWV's performance since inception has been attractive compared to the iShares S&P 500 Value ETF.

Value plus quality versus value
                                                  Past performance is no assurance of future success.

This week another ETF got on to the short list of qualified candidates. The new kid on the block is the Value Shares U.S. Quantitative Value ETF (QVAL) offered by Alpha Architect. QVAL incorporates quality in several ways. First, it has forensic accounting screens to avoid firms at risk for financial distress or manipulation. Then it filters for financial strength using a modified Piotroski/So F-Score. Finally, QVAL checks for sound business fundamentals through what it calls an "economic moat." This is a screen for firms having sustainable competitive advantages, a la Warren Buffett.

QVAL's management uses the enterprise multiple to determine value. They select  the top 10% of their large cap universe based on value, then drop the bottom half of these based on quality. The remaining 50 stock portfolio is equal weighted and rebalanced quarterly. QVAL's annual expense ratio of 79 basis points is high compared to PVW and QCELX, but QVAL is the most focused fund among the three, selecting only the top 5% of quality/value stocks in their mid/large cap universe, compared to PVW's 20% and QCELX's 40%. In looking at any of these enhanced value programs, you should consider an alternative such as the iShares MSCI USA Value Factor ETF (VLUE) that selects 20% of its benchmark universe and has an annual expense ratio of only 15 basis points.


Value investing in general poses risks that all investors should be aware of. One of these is high tracking error relative to the market. Value can go through sustained periods of under performance, such as during the 1990s. From 1994 through 1999, value underperformed growth by over 10% per year! With focused portfolios of just 50 stocks, PVW and QVAL can have much higher tracking error than other value funds. Value investors need to have a long-term investment horizon and a high tolerance for prolonged periods of underperformance.

There is also the potential problem of overfitting the data which comes from data mining. The use of filters and multiple selection criteria by all the above mentioned funds increases their chance of disappointing ex-post returns going forward.

Value investing with focused portfolios, such as those of PWV and QVAL, is also subject to high volatility and high worst drawdowns. Investors should be prepared for these as well.[2] Unfortunately though, investors sometimes lose sight of this. They panic and act counter to their best interests when confronted with severe drawdowns once bear markets arrive. In a survey of its members since 1988, AAII found that the highest weight to cash and the lowest weight to equities was in March 2009, right at the bottom of the worst bear market since the 1930s.

There is a way, though, that one may mitigate some of this harmful behavior. It is by using absolute momentum. (You didn't think I would write a long post like this without mentioning momentum, did you?) My research paper on absolute momentum and my new book show how to use trend following absolute momentum to reduce the expected drawdown of most any investment opportunity. The chart below of absolute momentum applied to the S&P 500 illustrates this.

  Downside reduction through absolute momentum

One could also incorporate value into a dual momentum-based model, such as the one featured in my new book. Unfortunately, value does not respond as well as relative momentum portfolios or the market itself to trend following filters. But by adding an absolute momentum filter to value-based holdings we should get some drawdown protection.Good luck to all you value investors!

[1] AQR has this same kind of broad participation in their momentum fund, where they hold 47% of the 1000 stocks in their selectable universe. Why they do not target factor profits more remains a mystery to me. Perhaps they expect so much capital to enter their funds that they expect liquidity issues. This may also explain why their portfolios are, for the most part, capitalization weighted instead of value or equal weighted.
[2] We found in examining the Ken French data of value, operating profits, and the joint sort of value and operating profits from 1964 through 2014, that the combination of value and operating profitability had even a higher volatility and worst drawdown than value or operating profits themselves.

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