By Jack M. Forehand (@practicalquant) —
Factor investing requires a lot of patience. Despite the fact that research shows that many factors can produce outperformance over long periods of time, all of them will struggle at times in the short-term. And those struggles are typically long and difficult enough that most investors will abandon underperforming strategies in favor of what is working now. When that happens, that typically signals a bottom for the factor is near.
At Validea, we track several hundred factors in our guru-based models that run the gamut from value to growth to momentum. Our historical testing shows that mean reversion in factors, particularly value factors, can be a very powerful force. The longer and more a factor is out of favor, the stronger its performance tends to be when things reverse.
So I thought it would be interesting to take a look across the factors we follow to see what is the cheapest right now.
Value stocks have been underperforming for a decade now, so it’s no surprise that nearly all the cheapest factors are value related. The cheapest one, however, also has the distinction of being the most loved factor, and the most unloved factor, all at the same time, which makes the discussion of its future prospects an interesting one.
The Price/Book ratio is probably the most commonly used factor in value. When Fama and French published their three factor model in the early 90s, they found that a low Price/Book ratio was positively correlated with future stock returns. That led to a huge uptick in money following it.
Price/Book has more money following it than any other factor. It is the primary factor Russell uses when it build its value indices, which have a lot of capital invested in them. It is also the value factor used by Dimensional Fund Advisors, which manages over $500 billion, for its funds.
That huge pool of money following Price/Book makes it the most loved value factor in terms of the assets following it.
With that amount of capital following the factor, you would expect its effectiveness to be reduced. And data indicates that may be exactly what has happened. Since January of 1995, the Russell 3000 Value Index has returned 9.99% annually, while the Russell 3000 Index has returned 10.12%. So adopting a value tilt using Price/Book has not produced the outperformance predicted in the academic research for the last 20+ years.
There are a couple of arguments as to why this has happened. First, as previously mentioned, when you put a huge amount of capital behind a factor, and when that capital tends to be permanent (sticking with the factor through ups and downs), that factor should lose some or all of its effectiveness. Second, share buybacks have become more common as time has gone by. When a company buys back shares, it reduces both its market capitalization (by reducing shares outstanding) and its book value (since either cash is subtracted to buy the shares or debt is added). The net result of this is a higher Price/Book ratio. This can have the effect of making a company look less attractive from a valuation standpoint, even though it is engaging in behavior that is beneficial to shareholders.
This combination of significant permanent capital tied to the Price/Book and the accounting basis for the reduction in its effectiveness has led to a transition. The best and most thoughtful minds in the quantitative investment business now almost universally hate the factor. They tend to prefer more advanced ratios like Enterprise Value to Operating Earnings or even different more common metrics like the Price to Earnings ratio. And those factors have all worked better in recent years. So despite being the most loved value factor in terms of money following it, the Price/Book has become the most hated one in the active management community.
Being the contrarian that I am, I think that creates an opportunity, especially considering that the Price/Book factor has become extraordinarily cheap.
Below is a chart from Research Affiliates. It looks at the valuation of a group of factors relative to their historical norms. The highlighted areas are the historical ranges (the 10th percentile to the 90th percentile) and the white dot is the current valuation. As you can see, most factors fall somewhere in those historical ranges. The value factors tend to be cheap right now on balance, and factors like beta and liquidity tend to be expensive. This is what you would expect given what has happened in the market in recent years.
But there is one factor that stands out based on valuation. If you look at the highlighted green box for the Price/Book when applied to small stocks, you will see it is well below the historical confidence range (meaning it is as cheap as it has ever been). The factor is also very cheap, though not as cheap, when applied to large stocks (the left most bar).
Our own internal data backs this up as well. The chart below looks at the ratio of value to growth stocks using Price/Book. When the number is high, the Price/Book factor is being rewarded and value stocks selected using it are outperforming. When it is low, growth stocks are outperforming and the factor is not working. As you can see, the current value is almost at the bottom of the range. So the result with the long-term Research Affiliates data is the same as the result using the most recent decade.
Obviously, none of this guarantees anything about the future since factors can stay cheap for long periods of time. But we have found that the longer a factor stays cheap, and the cheaper it becomes, the stronger the future returns can be. So if you are a believer that value investing will bounce back at some point and you are looking to find the cheapest stocks that will benefit when it does, the Price/Book ratio could be a great place to start.
Photo: Copyright: pogonici / 123RF Stock Photo
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.