"Value investing is at its core the marriage of a contrarian streak and a calculator." - Seth Klarman
There are many successful value investors that have made a name (and a fortune) for themselves exploiting irrationality in the stock market by identifying dislocations between prices and true long-term value. Value investors compare their perception of the future versus that which is being collectively priced in by the market for a given security. The market price of a stock at any given time represents the present and future value of a company. Although the present value of a stock can be known with relative certainty by looking at a company's financial statements, the future value of the company is unknown and must be discounted to account for the uncertainty of a company's future prospects. When an investor perceives the future to be rosier than that of what the market is discounting, a stock is considered to be undervalued.
Typically, value investors are drawn to companies which have fallen out of favor with the market because the future value of such companies may not be fully reflected in current prices. This is why many value investors are considered to be contrarian in nature. Warren Buffett's well known mantra is that he "attempts to be fearful when others are greedy and to be greedy when others are fearful."
Out of favor stocks tend to trade at lower valuation multiples (price divided by earnings, cash flow, book value, etc) than their more popular counterparts. This makes sense given the market by definition is collectively more negative on the future prospects of these companies. These valuation multiples can be thought of as hurdles for investors; the higher the multiple, the better the company will have to perform in the future in order to increase the price of the stock. Benjamin Graham, who is widely considered the father of value investing and was influential in shaping Warren Buffett's career, wrote about this in his famous book Intelligent Investor,
Common stocks with good records and apparently good prospects sell at correspondingly high prices. The investor may be right in his judgment of their prospects and still not fare particularly well, merely because he has paid in full (and perhaps overpaid) for the expected prosperity.
Most value investors would argue that a "value premium" exists whereby investors can generate excess returns by simply investing in stocks which trade at low multiples relative to the market. To isolate and capture this value premium QuantShares recently launched their US Market Neutral Value Fund (CHEP). This fund scores the 1,000 largest stocks in the Dow Jones US Index by three valuation metrics:
- Price relative to Expected Earnings per Share over the next 12 months
- Price relative to Cash Flow per Share over the preceding 12 months
- Price relative to current Book Value per Share
QuantShares takes the best 20% of stocks (those that look the cheapest) within each of the ten stock market sectors and purchases an equal dollar amount in each. The fund then takes the worst 20% of stocks (those that look the most expensive) within each sector and sells an equal dollar amount short. In doing so CHEP creates a long/short portfolio that has hedged out the directional risk of the market and isolated the relative performance of the "cheap" stocks versus the "expensive" stocks. Table 1 shows a recent snapshot of the CHEP portfolio construction showing the balance between its long and short portfolio within each sector.
The value bent of the portfolio is summarized in Table 2 which shows several valuation metrics for the long and short portfolios.
Although the ETF is less than a year old, the rules based strategy underlying the index was back-tested to the end of 2001. The results of the back-test as well as the live data through the end of June 2012 versus the S&P 500 (SPY) are shown in Chart 1 and Table 3 below.
Understanding that backtested data must always be taken with a grain of salt, the results of the backtest are very impressive. The long/short construction of the CHEP portfolio does a good job reducing risk which is seen in the volatility, down return capture, worst 12 months, and maximum loss statistics. The fact that the downside capture ratio is negative (albeit only slightly negative), indicates that the strategy can produce positive returns even in down markets. The long/short construction also reduces the correlation to the S&P 500, which makes it an excellent diversifier to an equity portfolio. Over this time period, one would have to argue that a "value premium" did exist and that it was quite significant, which is why CHEP outperformed the long only US equity index of the S&P 500. Finally, the higher Sharpe ratio indicates that CHEP would have been efficient in generating higher returns with less risk.
On the flip side, it is disconcerting to see that the lion's share of the returns came from early 2002 through mid 2007. This might be explained by the fact that value stocks were out of favor with the market through most of the 1990s as money flowed into high flying technology stocks. The "reversal to the mean" in these stocks could account for the relatively large and consistent returns for this strategy during this time period. Looking at the recovery since the 2008 credit collapse shows a much different picture where the value premium has actually been negative over the past several years.
It remains to be seen whether or not QuantShares has developed a product which can successfully capture the value premium that so many investors have made their career exploiting. On the surface there are many aspects of the rules based construction which we find appealing including the market neutrality and valuation exposure. We do think CHEP is a unique product which has the potential to produce positive returns regardless of the direction of the overall market. Alongside other holdings in our portfolio it should increase diversification and better position us to navigate difficult market environments. For this and other reasons we've chosen to include it as an Absolute Return holding in our Diversification 2.0 portfolio construction.
Additional disclosure: Transparency is one of the defining characteristics of our firm. This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities. It represents only the opinions of Season Investments or its principals. Any views expressed are provided for informational purposes only and should not be construed as an offer, an endorsement, or inducement to invest.