Multnomah Group’s investment philosophy rests heavily on the belief that “beating the market” is exceptionally difficult. Our proposed investment menus tend to emphasize passive investments with a keen eye on fees. However, we are also strong believers in the body of academic research that has, through empirical data, shown that it is possible to generate returns in excess of the broad market return with the use of style factors. Some of you may have heard us use the phrase, “We like to have tailwinds supporting our active managers.” Style factors serve as the tailwind.
This is the first in a series of blog posts in which we hope to provide the thinking behind these style factors. We will not be attending to all factors, but rather focusing on the factors receiving the most press. We would like to start this journey with a look at value investing.
Investment managers’ method towards value investing vary in the specifics but are similar in that they are seeking to invest in companies whose intrinsic value is higher than the current market value. In other words, value investors focus on valuation metrics that help to gauge how much a company is worth. For example, the most common forms of deciphering the value of a company is with metrics such as price-to-earnings ratio and price-to-sales ratio. A more thorough analysis likely includes conducting a multi-year cashflow projection, either with the use of dividends, buybacks, or free cashflow, then discounting the value of that projected cashflow back to its worth today. Again, the idea is to purchase shares of a company that is trading today at a price that does not fully reflect the cash generating ability of that business. Below is a snapshot of the relative fundamentals of the Russell 3000 Value Index against the broad based Russell 3000 Index.
|
Fundamentals * |
Dividend Yield (%) |
Price/Earnings |
Price/Book |
|
Russell 3000 Value |
2.46 |
16.55 |
2.00 |
|
Russell 3000 |
1.86 |
20.51 |
3.09 |
*Data courtesy of FTSE Russell Fact Sheets as of 4/30/2018.
The above table clearly shows that value stocks provide higher dividend yields and lower valuations. This is not to suggest that value stocks WILL outperform in the near future as we, and others, are not capable of timing such a shift. The reality is that trends may persist for extended periods of time. For example, value stocks have underperformed the market over the past five years.
Especially in light of recent relative underperformance of value investing, why should investors still care? Again, empirical data going back decades shows that value stocks tend to outperform the market; however, they also tend to go through cycles when they underperform as well. In the long run, value stocks outperform the market. Ok, it’s fine to say that this strategy has worked in the past, but what makes us believe that it will in the future? For us to believe in this factor going forward, we must see a sound economic intuition to explain the reason behind why it works. As Ilmanen, Israel, and Moskowitz of AQR write, the value factor may work due to “investor behavioral biases, such as excessive extrapolation of growth trends, as well as risk-based explanations like value assets having greater default risk.” [1] In other words, the value factor seems to work because investors overlook the attractiveness of these companies, finding more appeal in sexy new product launches by other companies or not being able to see that fundamentals have changed. Also, these same companies may be riskier, and the market rewards investors for taking this extra level of risk.
Notes:
[1]“Investing with Style: The Case for Style Investing,” AQR. https://www.aqr.com/~/media/files/papers/investing-with-style-the-case-for-style-investing.pdf
Multnomah Group is a registered investment adviser, registered with the Securities and Exchange Commission. Any information contained herein or on Multnomah Group’s website is provided for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Multnomah Group does not provide legal or tax advice.
Any views expressed herein are those of the author(s) and not necessarily those of Multnomah Group or Multnomah Group’s clients.