Value Investing Indices Are Not All Created Equally

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During his recent interview with Tobias, Corey Hoffstein, co-founder and Chief Investment Officer at Newfound Research discussed why value investing indices are not all created equally. Here’s an excerpt from the interview:

Corey Hoffstein: Yeah, I mean, I think to your point, this is something we were chatting about before we started recording. We can talk about value as a style, but the way you implement it, again, it’s so meaningful to your conclusion. So price-to-book, that just very generic academic definition, peaked out in 2007. Most composite models that might do price-to-book and plus price-to-forward earnings, and enterprise value to sales might be included in there. Those get you to 2013-2014.

Corey Hoffstein: When you start including other craftsmanship concepts, so you’re going to look at the quality of the balance sheet. You might look at cross-industry signals instead of cross-market signals, so you might be sector neutral or industry neutral, has certainly helped you more in technology, for example. Different sort of portfolio construction. I mean, some of the signals that someone like an AQR might even use would be looking at, but we’re not just going to look cross-industry, we’re going to actually look at valuations of suppliers, economically linked companies, not just what the GIC tell us. Or they might have their own definitions.

Corey Hoffstein: And you see that some of those craftsmanship things using momentum for example, to keep you from buying losers, deferring purchases. DFA implemented that a couple of years ago. Those sorts of things kept a lot of value people at least in the game until late 2017, early 2018 and then since then it’s just been a loser for, it seems, everyone. Which is really interesting because again, it ties back to your considerations on your experience with value is very much tied to the specific choices you make of how you implement the concept.

Corey Hoffstein: Again, I should mention here, we’re very much talking about systematic value. I know there’s a lot of people who fight with you online in particular about what does value mean. We’re talking about the quant value sematic value here.

Corey Hoffstein: And so what I wanted to look at was really what I considered to be value 1.0 indices and these are really indices that got popular, well they’ve been popular for a long time, but products started coming out around them in the early 2000s.

Tobias Carlisle: That’s a broad one, like a Russell.

Corey Hoffstein: Exactly. This would be like a Russell 1000 value. And I think what’s really unique, well not unique, what’s really interesting, at least, about these indices is that the way they’re defined is they’re defined to break up the universe between value and growth. So if I were just to say, what does value mean? Well, value would mean I’m hopefully buying things that are priced cheaply versus their intrinsic value.

Corey Hoffstein: But that’s not actually the way that these Russell, S&P, MSCI indices are defined. What they say is, well, if we’re going to break up the world between value and growth, so what they’re going to do is they’re going to rank stocks on both value and growth simultaneously. So growth, they’re going to look at a number of metrics, price-to-value, price intrinsic value measures book value or again, enterprise value-to-sale, something like that.

Corey Hoffstein: Then they’re also going to look at growth measures, revenue growth, earnings growth, internal growth rates, Roe, that sort of stuff. And they’re going to simultaneously rank and they’re going to say value is the stuff that loads very heavily on the value metrics, but very poorly on growth metrics. Right? So think about what you’re buying there in that index. You are buying stuff that is very cheap, but probably cheap for a good reason because it’s not growing.

Corey Hoffstein: Then you go the other side of the scale which is we’re going to buy growth, which is growing very quickly high on the growth metrics but low on the value metrics, which is basically saying, yeah, we’re buying stuff that’s growing a lot, but it’s super expensive. Which you would sort of say like, well that just sounds like fair value then, right? It’s cheap but contracting, growing but expensive, it’s all sort of fair value. But that’s how those original value indices worked.

Corey Hoffstein: So the question of, is that cheap, is a very different question than a lot more of these smart beta products that have come out, more concentrated. And again, I think they keep improving every year where you’re not just looking at simultaneously ranking, you’re just asking on an absolute perspective like is this thing cheap? And if it’s cheap we’re going to include it without any consideration really, or maybe there is some consideration of quality and growth, but it’s not simultaneously split. So you end up with with subtly different answers to the question of is value cheap based on how you’re going to implement value.

Tobias Carlisle: And then the implementation that AQR takes, which is probably using as many signals as possible that are value-related signals, trying to drive it, perhaps more the way that a value investor would do it. In the sense that it’s not enough for it to be cheap on a book value basis, it needs to be generating free cash flows. The cash flows need to be actually turning into cash, piling up on the balance sheet being used to buy back stock. There needs to be some other considerations of health and that helps you perform, but it only helps up to a point.

Tobias Carlisle: One thing from, from Rob Arnott, and I thought Rob Arnott’s paper was very good and when I say it’s very good, it agrees with me, it’s basically my definition of it, And Cliff’s is in the same boat. I guess the question that every value investor wants to know is what drives the underperformance and when does it turn around or what do you look at to see, am I just going insane here buying value stocks when I can just go and buy a Tesla or something else that seems to be growing at a very high rate regardless of the valuation?

Corey Hoffstein: Yeah. What’s really interesting to me is, again, a lot of that actually ties back to how you’re constructing the portfolio. So those value 1.0 indices that I talked about tend to take very heavy sector bets. So you even if you use a composite, a lot of them will use a composite of different value scores, they tend to load very heavily on financials, be very underweight technology. So you can actually track the value premium over time by just looking at technology minus financials or financials minus technology. I think you had Lawrence Hamtil on the podcast a little while back.

Tobias Carlisle: Right.

Corey Hoffstein: I know this is an area that he has explored really in depth, right? But if you were to look at a more sector or industry neutral implementation of value, that would no longer be the case. You wouldn’t be having this big sector bet that’s driving the premium. So what makes this sort of era, this particular point in time, unique is it’s okay, I can accept that value underperformed technology for the last decade and that’s why value 1.0 indices have stopped working.

Corey Hoffstein: But when you start looking at someone like an AQR or a QMA who tends to neutralize those industry and sector bets and look at cross-industry valuations, well this now seems like a… situation. Because a lot of what the evidence shows is that these valuations, relative valuations between growth and value, are at historical highs. Not all time highs, right? This is not 2000.

Corey Hoffstein: But when you look at price-to-book, enterprise value-to-sales, price-to-earnings, forward earnings especially, you see that the love for value has definitely dissipated and those relative ratios of those fundamental measures are at decade highs. They’re not as high as some prior dislocations, but they certainly are cheaper today, at least on a relative perspective than they were five, six, seven years ago.

Corey Hoffstein: And it’s accelerated in the last year, so I think there’s certainly an argument that this is no longer just a sector issue, that this looks a lot more like a risk appetite issue that investors have just said, “we’re done with this.” And I think what’s really interesting about that in particular, I did this study, I not only looked at these relative ratios to say, well, how cheap is it versus growth? How cheap is it versus the market?

Corey Hoffstein: But I wanted to look on an absolute basis and say, well, how much are we going to get paid to hold this trade? If I’m going to buy value, assuming prices don’t change, is there a good carry argument? So I tried to back out the shareholder yield expectations and that’s another area where you see shareholder yield for value has accelerated versus growth over the last couple of years. So I think on a relative basis, you can at least say the attractiveness of what you’re going to get paid for making this trade is a lot higher today than it was five, six, seven years ago.

Tobias Carlisle: One of the great points that Cliff makes in his is that while we might not be at 2000-type extremes yet, there really aren’t any other analogs out there. So you’re either proceeding onto a 2000 extreme at this point or we’re turning around and it’s becoming a more normal environment for value where there is some sort of premium for holding value stocks. What do you think about that?

Corey Hoffstein: Yeah, I mean, I think the interesting thing about the market is the unexpected can always happen. So would we bet on another 2000 occurring? Well it’s still close enough in the rear view mirror that I think people are aware of it and are hyperaware of valuations. But on the other hand, at a certain point after a decade of growth just working, you can start to see the appetite for growth continuing. So I think there is an opportunity for this to potentially continue to extend.

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