The roots of value investing go back to 1934, the year Columbia finance professors Benjamin Graham and David Dodd published Security Analysis, a biblical volume that is still studied today. Graham and Dodd outlined a strategy for identifying stocks trading for less than their intrinsic value, though they did not frame their work in the context of market-beating returns. That notion came much later, when academics began testing ideas about market efficiency.
In the 1970s and 1980s, a growing body of evidence began to show stocks classified as "cheap" delivered higher returns, regardless of their beta - that is, even if they were not more volatile than the overall market. Sanjoy Basu published a 1977 paper arguing that the performance of stocks was consistently related to their price-to-earnings (P/E) ratios. Another important paper in 1985 found a similar relationship between stocks with low price-to-book (P/B) values and argued this was "pervasive evidence of market inefficiency."
Many subsequent studies supported the idea that it is possible to identify undervalued stocks by comparing market prices to the company's fundamentals. These came to be known as value stocks, as opposed to growth stocks, whose earnings are expected to increase at an above-average rate.
Building on these earlier studies, Kenneth French and Eugene Fama published a landmark 1992 paper that analyzed stock returns from 1963 to 1990 and confirmed the "value premium." Significantly, they found that a low price-to-book ratio was the best predictor of this excess return, and today this is the academic definition of the value factor. In practice, however, many investment strategies try to capture the value premium by screening for stocks with low prices relative to earnings, cash flow, dividend yield, or some combination of these.
Why have value stocks outperformed?
Everyone loves a bargain, so it might seem obvious that underpriced stocks should have higher expected returns. But the real question is why it's possible to identify value stocks in advance. In an efficient market, mispricings should be quickly identified and exploited, after which they should disappear. Yet the value premium seems to persist, and no one knows exactly why.
Some have suggested that value companies are inherently riskier. Compared with growth companies they have more uncertain earnings, higher debt levels, and are less flexible and slower to adapt to changes in the economy. Perhaps the value premium is simply compensation for these additional risks.
Others have offered behavioural explanations. Many value stocks look cheap because they have performed poorly in the recent past, which scares off investors who dwell on short-term returns. Often value companies seem boring (think utilities and banks) compared with the headline-grabbing growth companies with sexy new products and services. Perhaps investors overpay for that excitement.
What the critics say
Just as the economy goes through cycles, value and growth often take turns outperforming. John Bogle, founder of Vanguard, has argued that "neither strategy - growth or value - has an inherent long-term edge" and "there is no reason to expect either style to outpace the other over time." Even Warren Buffett - touted as the greatest value investors of all time - has said, "Market commentators and investment managers who glibly refer to 'growth' and 'value' styles as contrasting approaches to investment are displaying their ignorance, not their sophistication. Growth is simply a component-usually a plus, sometimes a minus-in the value equation."
It can take extraordinary patience for value investors to get through the inevitable rough patches. Growth stocks can outperform for long periods - in the US, value stocks lagged significantly throughout the 1990s. Even over the 10 years ending August 31, growth outperformed value significantly in the US (9.1% for the Russell 1000 Growth index versus 6.1% for the Russell 1000 Value, in USD) and international markets (5% for the MSCI EAFE Growth and 2.7% for the MSCI EAFE Value, in Canadian dollars).
Moreover, value investing strategies can be challenging to implement. They have traditionally involved analyzing and selecting individual stocks, which is notoriously difficult. Even if you can reliably identify bargains everyone else has somehow overlooked, it's hard to pull the trigger and sell once the market recognizes the stock's true value.
Experienced investors are also well aware of value traps. When a stock's price has declined recently, it could be an opportunity to buy a solid company at a bargain price. But the low price might simply reflect that the company isn't worth very much and may never recover.
How to access the value factor with ETFs
For Canadian investors seeking exposure to the value factor, there are several ETF options. They highlight the fact that "value" can be defined in many ways. While broad-market ETFs from different providers are more or less interchangeable, the same isn't true for value ETFs.
- The iShares Canadian Value (XCV) tracks an index that screens companies according to six measures, including trailing and projected earnings, book value and dividend yield. The fund holds 55 companies and weights them by market cap, so it is heavily skewed to the big banks.
- The First Asset Morningstar Canada Value (FXM) uses a different methodology that ignores yield and includes earnings revisions. It holds just 30 stocks - the Big Five banks are not among them - and weights them all equally.
Value ETFs in the US, not surprisingly, are more broadly diversified. Again, the methodologies differ, so it's worth making an effort to understand what you're buying.
- iShares recently launched a suite of factor-based ETFs that includes the iShares Edge MSCI USA Value Factor ETF (BATS:VLUE). This ETF tracks an index of 150 companies selected for low price relative to book value and forward earnings, as well as enterprise value to cash flow from operations (yeah, I had to look that up, too).
- iShares also offers a large family of US value ETFs based on S&P, Russell and Morningstar indexes. The iShares Core U.S. Value (NYSEARCA:IUSV) has the broadest coverage, with over 2,000 stocks. Others focus on large, mid and small caps.
- The Vanguard Value (NYSEARCA:VTV) tracks over 300 large-cap companies sorted according to the usual ratios (book value, earnings, dividends, sales). Vanguard also offers value ETFs focused on mega-cap and small-cap stocks.
- Among Canadian-listed ETFs, the First Asset Morningstar US Value (XXM.B) uses the same methodology as its Canadian counterpart, FXM, but targets 50 companies.
For international equities, consider the iShares Edge MSCI International Value Factor ETF (NYSEARCA:IVLU), which holds 260-odd stocks selected according to the same strategy as VLUE, or the older and larger iShares MSCI EAFE Value (BATS:EFV).
Vanguard Canada's new family of smart beta ETFs includes the Vanguard Global Value Factor ETF (VVL), which can hold stocks from all developed countries. This is an actively managed fund, however: it does not track an index, and there is no publicly available information on the methodology.
Finally, one might also classify the family of fundamental indexes as value strategies. Created more than a decade ago by Research Affiliates, they weight companies according to book value, cash flow, dividends and sales, which has led some to call them value strategies in disguise. (A similar argument can be made for dividend ETFs.) In Canada, ETFs tracking fundamental indexes are available from both iShares and PowerShares for Canadian, US and international equities.