We assign funds to any number of categories for comparative purposes: large cap or small cap, foreign equity or domestic, value or growth.
While useful for broad comparison, these categories don’t tell the whole story, particularly in value equity investing where risk profiles and performance expectations can vary dramatically.
Here we discuss three basic approaches to value investing: traditional value, deep value, and dividend income.
The traditional and deep value approaches typically share a capital appreciation objective and a focus on valuations, but have vastly different risk profiles. Traditional value managers generally focus on buying strong companies whose share prices are discounted relative to historical or industry norms, typically derived from a short-term market dislocation such as missed earnings estimates or a disappointing product launch. (You may sometimes hear investment managers refer to this approach as behavioral economics; in this context, they believe that the market often overreacts to short-term challenges.) In the case of smaller cap stocks, companies are less likely to be broadly covered by Wall Street analysts, allowing investment managers to arrive at a differentiated valuation. These price dislocations provide an opportunity to capture some growth in share price over a short-to-intermediate time horizon.
Deep value also focuses on discounts but looks for much larger dislocations. Their typical holdings have fallen out of favor with the markets, often due to industry developments (such as new regulations) or company-specific issues. Deep value managers rely heavily on industry and company research to develop an analysis that is differentiated from Wall Street expectations. They often look for turnaround opportunities – management turnover, increasing margin compression, growth in new markets, or ancillary business lines, etc. By initiating positions at a steep discount, deep value managers have a larger growth opportunity over an intermediate-to-long horizon. These managers generally experience periods of greater volatility and short-term underperformance as they are willing to be early to invest and often double down if stock prices decline further, however, the risk premium should favor long-term investors.
Dividend funds, with a current income objective, comprise the third approach to value investing. These funds often require that all holdings offer a dividend and may liquidate a position if that dividend payment is reduced or cut. Income managers generally believe that dividends are a signal of management discipline and often point to historical studies that show stock prices of dividend-paying companies have less volatility than the broad market. Dividend income funds typically outperform during periods of market stress as investors make the “flight to quality.” In recent years, dividend income funds have largely outperformed their peers based on a different market trend – a flight to yield – as low bond yields forced investors to look to equity. Some dividend income funds do have a valuation component, presenting a different challenge: high demand for dividend-payors drives up their stock prices, sometimes beyond what managers see as a fair value. Valuation-disciplined managers then have fewer opportunities to reinvest cash. Generally, dividend income funds will tend to underperform their peers and benchmark when investors are willing to assume more risk, but their lower volatility should smooth returns over the longterm.