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Bargain Hunt

Bargain Hunt: looking for value in global equities

10-05-2016 | Insight | Maarten Polfliet Investors looking for value in global equities have been disappointed in recent years, as ‘expensive defensive’ and growth stocks have held sway in markets. But over the long term, value investing can be shown to outperform growth investing, depending on the economic environment of the time, says Robeco portfolio manager Maarten Polfliet.

Speed read:

  • Value investing outperforms growth over the long term
  • Patience is a virtue to capture the value premium
  • It’s also important to avoid unrewarded risks
  • Dare to be different to achieve superior long-term results

Stocks trading at high valuations because of their expected higher growth – defined as so-called growth stocks – and stocks with defensive characteristics are sought after when global economic worries and macroeconomic issues start to bite. Both types have been in the ascendancy since 2014 as investors have preferred these stocks to chase higher returns.

Subsequently, value stocks on the whole have underperformed their growth counterparts in the past two years. However, since 1931, there have been significant periods when value stocks have done much better than growth stocks. The key to capturing this outperformance is patience, says Polfliet, manager of the Robeco Quant Value Equities fund.

Robeco Quant Value captures one of the strongest anomalies known to exist in equity markets worldwide: the value anomaly. The philosophy is to buy stocks at a price lower than their intrinsic value, and to benefit from dividend income and future price appreciation. This can be measured by comparing the market value of a stock to its fundamentals, such as book value or earnings.

But it is hard to successfully time the market in knowing exactly when to switch from growth to value, or vice versa. “There is no reliable killer indicator for this,” says Polfliet. “Market conditions can change, but it’s hard to tell when enough sentiment tips the scales one way or the other, and what causes it.”

Bargain Hunt: looking for value in global equities

The 5-year rolling return of US stocks shows that value investing (above the horizontal axis) has mostly outperformed growth investing since 1931. Source: Kenneth R. French data library, value weighted returns 1926-2016/3.

Patience is a virtue
It means that having the patience and stamina to ride out the vagaries of the market is essential to really profit from a value strategy over time, says Polfliet. “In quant we look at long-term data sets and see valid arguments for how the value strategy has worked in the past and should continue to work in the future,” he says.

“But it comes and goes, and is very irregular; that’s one of the reasons why it’s hard for people to capture the value premium. They see it performing well for a while, so they go into it, and then come out when it’s doing badly, so they never really capture the whole premium. You have to be in it long term for that and be very patient, and a lot of people of course are not patient; if the results aren’t kicking in straight away then they shy away.”

Robeco Quant Value uses value techniques along with other elements of factor investing such as momentum and low volatility to decide what to buy. Its core objective is to harvest the value premium most efficiently by using a stock selection model that aims to have high exposure to the value factor premium while simultaneously dealing with challenges that characterize conventional value strategies.

Avoid unrewarded risks in value investing
“The first hurdle to exploiting value is the risk associated with value investing,” he says. “The value premium is often seen as a reward for distress risk, and indeed generic values strategies can be tilted towards stocks with high distress risk, also known as default risk. These stocks are cheap for a reason (value traps). Robeco research shows that high-risk value stocks offer no additional premium compared to low-risk value stocks. This can be seen in the chart below. Hence, there is no need to invest in high-risk value stocks in order to capture the value premium. This is why our value strategy includes criteria to avoid unrewarded distress risk within value. This allows us to reduce unrewarded risks without sacrificing returns.”

Bargain Hunt: looking for value in global equities 

You can get the same returns from low-risk value stocks as high-risk ones. Source:
De Groot & Huij, “Are the Fama-French factors really a compensation for distress risk?” - SSRN working paper no. 1840551. Distress risk is measured relative to median distress risk within value (100%).

“Secondly, value investing can go against other established factor premiums such as low-volatility and momentum. One concern with a value approach is buying too early. Stocks that seem to be attractive from a value perspective but show further weakening in fundamentals will probably decline continuously in price. These value stocks go against the proven momentum factor. Our approach aims to avoid these value stocks by taking analyst revisions and price momentum into account.”

More concentrated value exposure
“By avoiding unrewarded risks and through the integration of low-volatility and momentum factors, Robeco Quant Value can be selective and create a more concentrated value portfolio than a generic approach, resulting in enhanced returns. It is not necessary to limit the impact of unrewarded risks by diversifying over a very large number of stocks. In contrast, our approach achieves a higher active share and a deeper exposure to the value premium.”

Polfliet says it is a proven fact that price/earnings differences between stocks are significantly larger than what would be justified by future earnings growth. “Value stocks do exhibit below-average earnings growth for a while, and growth stocks above-average earnings growth, but not nearly enough to justify their large P/E ratios. So it is clear that investors underestimate the earnings growth potential of value stocks, and overestimate the earnings growth potential of growth stocks,” he says.

He says the Quant Value fund is currently trading at 9 times earnings, resulting in an earnings yield of 11%, while the market is trading on 17 times earnings, with an earnings yield of 6%. “This 5% higher earnings yield resulting from paying a low price for fundamentals gives a real margin of safety,” he says. “It lowers the risk of equity capital loss and avoids the risk of overpaying for the growth potential of expensive stocks and getting poor future returns. So even if the earnings of all the stocks in the portfolio would drop on average by 45%, we would still be at the same valuation as the market. And do we really believe that this would happen over the whole portfolio? This is very unlikely. It gives us a lot of potential upside.”

Bargain Hunt: looking for value in global equities

Robeco Quant Equities versus the MSCI AC World Index at 31 March 2016. Note the significantly lower price/earnings and price/book ratios and higher dividend yield in the fund. The value of your investments may fluctuate. Past performance is no guarantee of future performance. Source: Robeco

Greed and fear
Human instincts under the classic adage of ‘greed and fear’ have played a part in value investing’s recent unpopularity, Polfliet believes. “You can profit systematically from the sound principles of value investing, but it means that you sometimes buy stocks that everybody else is selling, and as a human being this can sometimes cause people to become anxious,” he says. “That is often why people can’t stand it, and they shy away from it from time to time. I also have those kinds of human feelings, but I work with a model which doesn’t have fear or emotions; it sticks to the process and that’s the way to achieve good returns.”

That model is now producing some interesting signals for stocks in the energy sector, Polfliet says. “Value investors in general are becoming attracted to energy sector stocks, such as the energy sector overweight in the MSCI Value Weighted index. This sector contains more attractive opportunities now that it is out of favor and is trading at 1.3 times book value, has a 4.4% dividend yield and a P/E in line with the market. However, the oil sector is also witnessing bankruptcies and defaults, and it remains important to be selective, he says. “Some stocks are distressed and so they are cheap for a reason. It is important in our process to avoid the risky value stocks. As said before high risk value stocks generally make the same returns as the low risk ones, so you don’t need them to capture the value premium.

Conversely, value investors found less attractive value stocks in the Health Care sector, which became expensive (trading at close to 24 times earnings) in recent years, driven by merger and acquisitions activities and the preference for defensive stocks.

Dare to be different
What has made the situation worse for value investors is that the market against which funds are judged have been tilted towards growth stocks, whose shares shouldn’t be bought by value funds, because they are expensive and trading at high price to fundamentals and probably too expensive relative to their perceived true growth potential. This has led some value funds to underperform global indices when there was nothing wrong with the fundamentals of the underlying investments. As most fund managers are judged on their relative performance, it has caused frustration in being ‘punished’ for simply not following the herd. Polfliet reminds investors of a famous phrase in this regard. “Please remember Sir John Templeton, who said: It’s impossible to produce superior performance unless you do something different from the majority”.

Maarten Polfliet

Senior Portfolio Manager

"Broadly diversified portfolios based on a rules-based approach are a perfect way to systematically profit from the sound principles of value investing."
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