The Value Of Value

| About: Guggenheim S&P (RPV)
This article is now exclusive for PRO subscribers.


My recent series of articles discusses the performance of factor tilts over very long time intervals.

This article discuss the long-run market-beating return of the value factor.

The article further discusses the difference in performance of the value factor in "up" and "down" markets, which suggests how to potentially time this factor tilt.

Regular readers know I have recently updated my "5 Ways to Beat the Market". These strategies (size, value, low volatility, dividend growth, equal-weighting) have outperformed the equity market benchmark over long time intervals, generating structural alpha through factor tilts. In follow-up articles, I am trying to further illustrate the efficacy of these strategies and demonstrate when these factors might most be apt to boost portfolio performance.

In yesterday's article, I illustrated the "Very Long-Run Excess Returns From Equal Weighting," which illustrated that equal-weighting market components has outperformed the more traditional capitalization-weighting in a dataset spanning nearly ninety years. Equal-weighting delivers its higher absolute returns from its periodic rebalancing, a contrarian value strategy that purchases stocks that have underperformed and sells stocks that have risen in value. Equal-weighting also captures size premia through investing dollars in a lower average company size.

It should not be surprising that size and value were the contributors of long-run outperformance. After all, the dataset from where I am gleaning information is by Dartmouth professor Kenneth French. Along with Nobel laureate Eugene Fama, French popularized the Fama-French Three-Factor Model, which used size, a value measure (book-to-market), and beta to more accurately describe stock returns.

In this article, we are going back to the well and examining the above-market returns attributable to the value factor in the voluminous French dataset. In that dataset, portfolios are formed based on their ratio of book equity/market equity value at the end of each June. Book equity is from the last fiscal year. In this article, I am going to be examining three portfolio slices - the bottom 30% of total U.S. stock market value based on book-to-market, the middle 40%, and the top 30% based on book-to-market. The highest book-to-market stocks are the value cohort, as the market has underpriced these stocks relative to their accounting value.

As one might expect, the high book-to-market cohort trounced the lower book-to-market cohorts. Summary statistics are below:

A cumulative return series of the value-weighted cohorts below should further illustrate this tremendous long-run outperformance. The incremental 328bp return for the highest book-to-market cohort versus the lowest book-to-market cohort translates into 14x more cumulative wealth over the 90-year horizon.

Note that the value factor has been higher-risk as measured by the annualized standard deviation of monthly returns. That is also true in my "5 Ways" series, as the Pure Value Index replicated by the Guggenheim S&P Pure Value ETF (NYSEARCA:RPV) is the only one of the five representative indices that has had higher variability of returns than the market.

Value has delivered long-run outperformance, but that outperformance has been compensation for its higher risk. Is there a way to tactically allocate to value strategies?

Below I have broken the returns of the book-to-market cohorts into two separate groups, based on the annual performance of the S&P 500 (NYSEARCA:SPY). In down years for the broad market index, the value factor has not materially underperformed; however, in up years for the S&P 500, the value factor has generated material outperformance. In the 65 "up" years in the sample set, the highest book-to-market cohort has delivered annual returns approaching 25%.

Tuesday's article, "Dividend Aristocrats and Equal Weighting Remain Cycle Busters," illustrated that combining a strategy that outperforms in down markets (dividend growth) with a strategy that outperforms in up markets (equal-weighting) has generated consistent market outperformance this century. Not to be outdone by these two factor tilts, in a coming article look for an additional combination strategy involving value that has also generated consistent market outperformance.

Disclaimer: My articles may contain statements and projections that are forward-looking in nature, and therefore inherently subject to numerous risks, uncertainties and assumptions. While my articles focus on generating long-term risk-adjusted returns, investment decisions necessarily involve the risk of loss of principal. Individual investor circumstances vary significantly, and information gleaned from my articles should be applied to your own unique investment situation, objectives, risk tolerance, and investment horizon.

Disclosure: I am/we are long RPV, SPY.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.