By Jack Forehand (@practicalquant) —
When you look up a word in the dictionary, you expect to get a pretty clear definition of what it means. There obviously is gray area with some terms and some have multiple definitions, but in general a word’s definition will give you a pretty clear understanding of it.
When it comes to investing, it is common to take that mentality and assume it also holds. The reality, however, is that it often doesn’t. Investors use words like value and momentum and quality to describe how they select stocks, but those terms can mean many different things, and those differences can have a huge impact on investment returns. Understanding what is going on under the hood for each approach is crucial to understanding both the potential return and the risk.
The Different Definitions of Value
Take value investing for example. Of the twelve gurus we follow on Validea, nine of them would be considered primarily value-based. Behind the scenes, though, their strategies are very different. Approaches like those based on Ben Graham or accounting professor Joseph Piotroski look for deep value stocks that are out of favor and among the cheapest in the market. These companies typically have serious problems, but the market typically overestimates those problems, which allows for excess return over time. Other approaches, like those based on Warren Buffett or Peter Lynch couple value with quality and growth. The companies they select will typically not have the kind of problems as deep value stocks, so the strategies won’t get as much direct exposure to the value premium, but they will get exposure to other factors that have proven themselves over time.
Even within deep value, there are still many differences between strategies that can have a large impact on returns. One of the primary reasons is the use of different metrics to define what value is. The Price/Book, Price/Earnings, Price/Sales, Price/Cash Flow and Enterprise Value/EBITDA ratios are all widely used by investors, and each has a very different return profile. There are also other questions that need answering when building a value portfolio like: How many stocks you hold? Which universe you select your stocks from? and How often you rebalance? These can have a major impact on returns.
To illustrate this, let’s take a look at three popular value ETFs. These funds all have value in their names, so the tendency of investors is to believe they are the same, or at least very similar. The reality, though, is quite the opposite.
iShares S&P 500 Value Index (IVE)
|Alpha Architect Quantitative Value ETF (QVAL)
Vanguard US Value Factor ETF (VFVA)
|Number of Stocks:
|Primary Factors Used:
|Price/Book, Price/Earnings, Price Sales
|Multi-Factor, Not Disclosed
If you were an investor looking for exposure to value and you thought these 3 funds were similar, you would be in for quite a surprise once you invested. Each fund selects stocks from a different universe. The first is a large-cap fund that selects stocks from the S&P 500. The second selects stocks from a larger universe of around 1000 stocks that includes mostly large-caps stocks and some mid-caps. The third selects from 3000 stocks the encompass almost all of the US investment universe. So before these funds even think about applying their value criteria, they are guaranteed to produce very different returns just because they select from completely different groups of stocks.
In addition to the differences in universes, they also look at portfolio concentration very differently. QVAL seeks aggressive exposure to value with only 40 stocks. That allows it to most directly capture the outperformance of value over time. But that will come at the expense of more volatility along the way, which will make the fund more difficult to stick with for many investors. The other two funds have a lot more stocks. They likely won’t be able to capture as much of the value premium and will offer more index like returns, but they will also provide a smoother ride along the way, allowing more investors to stick with them.
Finally, all 3 of these funds define value in very different ways. The first uses a fairly conventional definition that uses Price/Book, Price/Earnings and Price/Sales. The second uses the Enterprise Value/EBITDA multiple, which is a more complicated factor that is probably the best performing value factor in historical testing. The third uses an undisclosed system. Despite what many investors think, individual value factors typically do not have very similar performance, especially in the short-term. For example, the Price/Book factor has lagged all the others badly in recent years.
The Importance of Knowing What You Are Getting
These are just some of the differences that can exist among value approaches. If you look at the performance of these three funds, or other value funds, on a year by year basis, you will see that they vary substantially from each other. The point is not that one approach is better than the other. The point is that it is essential to know what you want in investing and what you are getting and to match those two. If an investor wants substantial outperformance when value is working and they buy IVE, they are likely to be disappointed. If an investor wants to mostly track an index with a slight value tilt, they are going to be in for a big surprise if they buy QVAL. The devil is often in the details. Paying attention to those details can be key to achieving success.
Jack Forehand is Co-Founder and President at Validea Capital. He is also a partner at Validea.com and co-authored “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies”. Jack holds the Chartered Financial Analyst designation from the CFA Institute. Follow him on Twitter at @practicalquant.