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Efficiently harvesting the value premium

15-09-2014 | Insight | Maarten Polfliet Value is one of the oldest factors in the world. Graham and Dodd already laid the intellectual foundation in the 1930s for what would later be called value investing and Basu published the first academic study in 1977 documenting the existence of the value premium.

Value investing, buying stocks with a low price to fundamentals, carries the prospect of gaining an attractive premium of 2-3% to the market. But gaining the value premium is not as easy as it seems. It changes over time and selecting the right value stocks is challenging. To profit from it you need sound value investing principles and stick with them. So what should you take into account? Robeco Quantitative Value Portfolio Manager Maarten Polfliet explains how to reduce unrewarded risks, the integration of other factors when selecting stocks and the importance of a broad investable universe.

What is the investment belief behind Robeco Quantitative Value?
It combines two investment approaches; investing in stocks where you can harvest the attractive value premium and applying a rules-based approach. We apply the value concept of buying stocks that trade at a low price relative to their realized fundamentals rather than investing in concepts based on future expectations and predictions as is the case with growth stocks. In the end, a bird in the hand is worth two in the bush.

Broadly diversified portfolios based on a rules-based approach are a perfect way to systematically profit from the sound principles of value investing. This means you sometimes buy stocks that everyone else is selling, and sell stocks that everybody else is buying. This social pressure can cause anxiety. That is why we use a rules-based approach; this has no barriers of fear, keeps you on track and ensures that you fully exploit the value premium.

How is your value strategy different from others?
We take a systematic approach to capturing the value premium. A rules-based approach helps because it allows you to stick to your investment style. Based on our experience in analyzing factor exposures it is important to realize that although many investment funds or smart-beta indices carry the ‘value’ label, they aren’t value strategies at all. Their actual exposure to the value factor is low.

Often the value premium is seen as a reward for risk and indeed generic values strategies can be tilted towards stocks with a high distress risk, also known as default risk. These stocks are cheap for a reason. With our approach we avoid such value traps. Because our research shows you do not need to invest in high-risk stocks in order to capture the value premium. That is why we included criteria to avoid high distress risk, poor financial strength and companies with an aggressive accounting base to achieve sound earnings power in our selection of value stocks. This allows us to reduce unrewarded risks without sacrificing returns.

Beside this we integrated low-volatility and momentum factors into our quantitative value strategy. This is because we do not want to invest against these two proven factor premiums. Take price momentum for example. A concern with a value approach is buying too early. A stock may seem to be attractive from value perspective. But if its price continues to decline due to further weakening in fundamentals it isn’t attractive to have in your portfolio.

Some investors worry that value investing is currently too popular. Is it easy to select suitable stocks for your portfolio?
The investable universe we can select from is so broad that there is always a segment with relative low price to fundamentals. There are still a lot of companies out there with an attractive valuation. Moreover, value investing is a long-term game. It is normal for interest in value stocks to fluctuate. Sometimes investors are interested, and at other times they are disappointed. For example if value lags the market that is driven by momentum and growth stocks.

'Avoiding negative momentum prevents you from buying too early'

If value investing always works, it will be arbitraged away, but it doesn’t. Interestingly, even though the value premium has been documented many times since the 1970s, the factor continues to perform. So it works over time, but the interest is irregular.

And how is your approach different from smart-beta funds?
Our active approach is designed to capture the value premium more efficiently than the value oriented smart-beta indices. We aim for a better risk-return profile by avoiding unrewarded risks and unnecessary turnover, and going against other proven factor premiums. Furthermore, we would like to stress that although these smart-beta index strategies look-and-feel like passive they are active strategies at heart.

Finally the construction of those smart indices results in a tilt towards large caps. This is a pity for investors because it holds them back from the value stocks opportunities within the small- and mid-caps segment of the market. Our way of constructing a portfolio is different. We can chose from a broad investable universe of more than 3,000 stocks and objectively compare large, mid and small cap stocks to select the most attractive value stocks. Due to our approach of avoiding unrewarded risks and the integration of low-volatility and momentum factors we can be very selective and create a high conviction value portfolio with a higher active share. Our current portfolio has around 200 stocks resulting into a much deeper exposure to the value premium.

Your strategy is young. What is Robeco’s experience with value investing?
The strategy is new, but Robeco’s experience with all its ‘ingredients’ is extensive. Value factors have been part of all our quantitative equity models since the early 1990s. It is the same for the momentum variables which we take in consideration in this value approach. And we have had experience with the low volatility factor since as early as 2006. So application of the value anomaly and the other factors are at the heart of Robeco’s quantitative equities investing.

Where does investor interest for your strategy come from?
It is mostly coming from institutional investors who want to strategically allocate to the value factor. Allocating to this is part of their ‘investment belief’ based on the sound principles of value investing and the tremendous amount of evidence for value as one of the largest factor premiums. Often they want to combine it with investments in other factors: either Robeco Conservative Equities or Momentum, but also factor strategies managed by other managers.

Diversification is important because factor premiums are not constant over time. But the precise mix of value, momentum and low volatility can be different. Are you interested in absolute performance or relative performance?

Some investors only chose the value and momentum factors because they focus on outperforming the market cap weighted index. While others also include low volatility which has more an absolute risk-return focus. It all depends on investor preference.

Interest in the quality factor is increasing. What is your opinion of this?
Investors are looking for new factors after value, momentum and low-volatility, but is quality really new? The old value school always looked at safety, stability and profitability in addition to a low price to fundamentals. At our quantitative equity strategies we have been exploiting variables related to quality for many years. Beside this there is still a lot of discussion among academics on what the quality factor is precisely. We are monitoring the discussion and continuously check, as we have always done, which variables perform and which do not.

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