A Deeper Dive Into Value Vs. Growth

Summary

• Value Funds are underperforming and trading at low multiples when traditional investment logic says they should be outperforming.
• Life Insurance stocks are especially cheap and they could be signaling more trouble ahead.
• They have a small impact on the overall market but a much larger one on several popular dividend income funds.

"The first step in avoiding a trap is knowing of its existence"

- From Dune by Frank Herbert

If there’s one thing Americans can agree on here at the halfway mark of 2018 it’s that they feel more divided now than at any point in the last four decades and on any possible topic you can imagine. Politics, the national anthem, and all female reboots are all topics to be avoided at family functions but the one divide that no one can safely ignore is value versus growth and with two quarters of the year now in the books, growth is clearly eating value’s lunch.

As of July 2^nd, there’s an almost 1000 basis point spread between the YTD returns for the iShares Russell 1000 Growth (IWF) and iShares Russell 1000 Value (IWD) and that can have profound implications for exchange traded funds in the second half of 2018.

We collect and score hundreds of different data points on thousands of ETFs including various price multiples and dividend yields although they can be meaningless without a point of comparison. Some compare a fund to the broader market while others use that data looking for cheaper funds within a sector, but we also rank every equity compared to prior multiples to determine whether a fund is trading above or below its historical averages, making it easier to do a bit of trend spotting. Not surprising to anyone is that at the top you’ll find nothing but style-box growth funds and a handful of tech and consumer discretionary ETFs full of the names that make up the growth space and have absolutely crushed it over the last two years.

We’re more interested in why value funds, typically heavily weighted towards financials, have been lagging so far behind when most investment textbooks would tell you that a rising rate environment is good for the banks and insurance companies that make up the sector. The bottom rungs of our fundamental rankings are littered with numerous value funds including the SPDR Portfolio S&P 500 Value ETF (SPYV), which is now trading at price multiples that have only been lower in .3% of its 18+ year history.

What is noticeably lacking are sector funds representing some of the common value industries with only one, the SPDR S&P Insurance ETF (KIE), among the lowest 25 rated funds while its smaller iShares equivalent, the iShares U.S. Insurance ETF (IAK), isn’t nearly as much of a “bargain” as the SPDR S&P Insurance ETF (KIE).

Why that matters to us is that the end of a quarter is when many funds rebalance their portfolios meaning plenty of traditional index replicators have trimmed their winners to buy more of their losers while dividend income funds will go out searching for new holdings often by employing a series of predetermined steps that focus on valuation. The question we need to answer is whether insurance names are the value they appear or whether investors could be walking into a classic value trap?

The Test:

Our own data can tell us if a fund is cheap relative to its own history, but not whether it’s a good value. To answer that question, we need to go to the stock level where we used the excellent screener at Finviz.com to build out an investment universe, which is no small task. Not only are markets barely in the black this year but slightly less than half of all exchange traded stocks are currently above their 50 or 200-day moving averages.

Even the most common equity benchmark, the S&P 500, only has 53% of its components above their 50-day MA. Simply looking for domestic stocks trading off their recent highs and with a P/E below the S&P 500’s 24.8 literally brought up over 1,200 names.

Instead we decided to take the same approach used by many dividend income funds and use a set of investment criteria focusing on both value and sustainability of payouts. To do this we decided to dig up a favorite book on investing, Money Masters of Our Time by John Train, and use a sort of modified Benjamin Graham screen to separate the merely cheap from the good values. The criteria we used was straightforward looking only at:

• U.S. stocks (excluding REITS, MLPs and nonqualified dividend payers).
• Dividend payers with a yield at least equal to the ten-year Treasury yield of 2.83%.
• An earnings yield at least 2x that same yield on the ten-year, which translates into a P/E of 17.66.
• A payout ratio below 70.

Coming so late in a bull market and with such low interest rates it’s not surprising that our strict criteria produced a list of “problem children” with a heavy financial focus with 50 of the 116 names in that sector. That includes asset managers challenged by the rise of ETFs and a wide range of typically smaller banks (the median market cap on our list is only $737 million) who likely haven’t seen a big improvement in NIM or are facing challenges on the wealth management front. What did stand out was that the three largest life insurance companies out there: MetLife (MET), Prudential Financial (PRU) and Iowa’s favorite son Principal (PFG) made the list.

Traditional investment logic would say that those insurance companies should’ve been among the biggest beneficiaries of both the steady climb in Treasury yields and the recent defeat of the DOL Fiduciary rule but instead are trading at prices almost too good to believe (Read more here). Not only are all three down more than 20% from recent highs but PRU and PFG are trading at multiples in the high-single digits while MET and PRU are also trading at significant discounts to their book values. That’s not just cheap, that’s Chinese bank stock cheap.

Normally, when there’s a major difference between price multiples and book values, it’s the result of a temporary difference in expectations as investors are discounting the future earnings growth and the financials haven’t caught up. One example we can recall is how mortgage REITs traded at a substantial discount long before the housing market blew up but does the same situation apply here? At first glance, most would say no but after a deeper dive into the financials of PFG, we think the market might be onto something.

A Deeper Dive Into PFG

When studying financial stocks, the first thing you need to admit that it’s the Fed’s world, we’re just living in it. All equities are correlated to interest rates but that goes double for financial stocks and insurance companies have the strongest correlation of all. They depend on net investment income, the returns they generate managing their pool of assets collected as premiums and largely invested in fixed income securities to help drive their income.

As of the end of the first quarter, PFG currently has over $58 billion tied up in different bond issues, the bulk being investment grade corporate bonds rather than Treasuries and we spent hours testing different bond yields and spreads trying to chart the impact of changing rates on stocks. Frankly, it wasn’t time well spent and at the end of the day, it’s easier to stick with the ten-year yield where here you can see the weekly yield compared to returns for IAK, KIE and PFG.

You can see that insurance stocks were feeling the love in 2016 when they began rallying during the summer as the ten-year treasury yield rallied from its lows around 1.4% to 1.8% around election day but the big surge in yields after the Trump election (plus the general goodwill of the Trump rally) kicked it into overdrive. The broader IAK even continued to push higher in 2017 even as Treasury yields waffled and ended the year largely unchanged but the party was definitely coming to an end for PFG. Fast forward to 2018 and even the big jump in yields at the start of the year couldn’t light a fire into insurance stocks. What gives?

The easy answer is that investors are still doubting the Fed’s case for continuing to raise rates despite the strong economic growth of the second quarter and makes sense they’d think that. For years investors have doubted the market as it powered higher while the economy lingered through a period of slow growth although we’d point out that actual economic output has now been above potential for two consecutive quarters, typically a strong signal that more rate hikes are in the pipeline.

However, the impact of those investor expectations on yields and thus PFG’s bottom line can’t be denied. PFG’s net investment income has risen less than 10% in the last year (versus a 20% drop in premiums) despite the increase in long-term rates and those increases along with higher spreads are having a negative impact on PFG’s “other comprehensive income” as the company has substantial unrealized losses in its bond portfolio. Principals unrealized net gains from available-for-sale securities have gone from $163 million in 1Q 17 to an unrealized net loss of $800 million as of 1Q 18.

The second factor to consider with insurance companies is their product mix where most have a strong presence in the annuity business, something that’s been under serious pressure thanks to the DOL’s now ignored Fiduciary rule. The rule made commissioned products into villains and FINRA and the broker/dealer community were quick to cast them aside with most major B/D's eliminating commissioned products from retirement accounts while advisors were forced to have their clients sign letters essentially saying they weren’t acting in the best interests of the client by selling them such products. Awkward.

That helped to quickly cut profits and while the rule may be repealed, its legacy lives on with many advisors reluctant to use the products resulting in poor sales growth. Annual annuity sales have dropped by over $30 billion since 2015 while sales growth from 1Q '17 to 1Q '18 is expected to be negative for variable annuities and flat for fixed according to the LIMRA data bank (See Here)

Not surprisingly, all three of the stocks we’ve mentioned were big players in the annuity game although MetLife spun off its annuity business as Brighthouse Financial (BHF), which began trading in August of 2017 and is now down over 45% from its 52-week high. It’s not on our list because it lacks both a dividend or positive earnings to pay it out of while MetLife retains a nearly 20% ownership stake in the business. Going back to PFG’s first quarter report, its annuity business is a part of their Retirement Income and Solutions Group where operating revenue declined from $1.482 billion at 3.31.17 to $1.182 billion a year later.

That cut heavily into the gains made by their other insurance and asset management group and helped dragged down operating revenue by $157 million overall. With their RIS group making up 40% of revenue, PFG will be challenged to grow earnings going forward even with flat revenue growth unless rates go higher to lift investment income. Now those low valuations seem more reasonable.

Welcome To The Danger Zone:

These life insurers may be a canary in the coal mine but the problem with that analogy is their relatively small size and market presence makes them easy to overlook. As you can see in the table, all three life insurers put together only make up .42% of the S&P 500 or slightly more than 3% of the Financial Select Sector SPDR (XLF.)

They obviously carry a substantially higher weighting in two of the three dedicated insurance industry funds although KIE is equally weighted giving all three stocks the same allocation that MET has in just IAK. That’s helped KIE stay ahead of IAK in 2018 with the fund down 1.86% compared to IAK’s 6.2% loss despite holding many of the same names.

Where investors need to truly stay wary is in the dividend income space where funds following a set of strict criteria can easily add these three stocks despite their recent issues. Life insurers have a fairly mild impact on most of the larger funds in the space given they either have a market-cap weighted allocation system, a broad number of holdings or both, but there are two funds where these stocks can have an outsized impact on the portfolio.

The older and larger is the ALPS Sector Dividend Dogs ETF (SDOG), which follows the classic dividend dog philosophy and invests in the five stocks in each S&P 500 sector with the highest dividend payouts. Add that to a strong track record within the large value space and you have an easy choice for income-oriented investors who’ll be picking a serious overweight to life insurance stocks (click here for an in-depth comparison).

The newer fund on our list is the First Trust Rising Dividend Achievers ETF (RDVY), which has seen an almost 25% growth in assets in just the last 90 days. RDVY has a much stricter inclusion criteria than SDOG requiring that potential investments must have their larger current earnings versus their level three years ago while dividends have to be higher than the prior amount paid three AND five years before.

RDVY and SDOG both equally weight stocks but RDVY draws from the wider Russell 1000 and with no constraints on sector weights, financials make up nearly 30% of its portfolio with 2% in both PRU, PFG along with a 2% position in another insurer, Lincoln Financial (LNC), whose low dividend kept it off our list.

With 6% in life insurance stocks, RDVY might be the real canary to watch in case the insurance sector continues to head towards new lows.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

Assumptions, opinions and estimates constitute our judgment as of the date of this material and are subject to change without notice. ETF Global LLC (“ETFG”) and its affiliates and any third-party providers, as well as their directors, officers, shareholders, employees or agents (collectively ETFG Parties) do not guarantee the accuracy, completeness, adequacy or timeliness of any information, including ratings and rankings and are not responsible for errors and omissions or for the results obtained from the use of such information and ETFG Parties shall have no liability for any errors, omissions, or interruptions therein, regardless of the cause, or for the results obtained from the use of such information. ETFG PARTIES DISCLAIM ANY AND ALL EXPRESS OR IMPLIED WARRANTIES, INCLUDING, BUT NOT LIMITED TO ANY WARRANTIES OF MERCHANTABILITY, SUITABILITY OR FITNESS FOR A PARTICULAR PURPOSE OR USE. In no event shall ETFG Parties be liable to any party for any direct, indirect, incidental, exemplary, compensatory, punitive, special or consequential damages, costs, expenses, legal fees, or losses (including, without limitation, lost income or lost profits and opportunity costs) in connection with any use of the information contained in this document even if advised of the possibility of such damages.

Comments

[Snowy]

Thanks for the useful analysis.
PRU and MET could become more interesting following further drops.

[ETF Global]

First off, thank you for taking the time to read the article and ask follow-up questions. Our focus has been on trying to educate investors on how ETF’s work and impact the broader market. A big part of that is focusing on individual names and sectors and while the net takeaway on Principal Financial Group (PFG) was that the market might be right when it comes to how heavily discounted it is, the larger focus was on how that impacts certain dividend-oriented funds.

Focusing on bonds, you’re right in that the rising rate environment has begun to ding PFG’s bond portfolio of older holdings thanks to their lower coupons although PFG is dealing with other issues including widening spreads. Their portfolio is largely geared towards investment grade corporate bonds where spreads have widened the most recently thanks to a combination of strong new issuance without a strong increase in demand (www.bloomberg.com/...).

Part of that could just be investors anxious about whether rates will continue to rise but decreasing credit quality could also be a concern given how late we are in the market cycle and how much debt levels have risen overall. In the meantime, PFG only has a relatively small amount of bonds maturing in the near-term so the opportunities to reinvest in higher-paying bonds are relatively small. And while they wouldn’t incur any capital losses if they bought the bonds at par and held them to maturity, unrealized losses will still show up in comprehensive income although whether that gets noticed by anyone just looking at the headlines is anyone’s guess.

The bigger issue is their retirement income business and you hit the nail on the head with PFG’s asset management arm. The original focus of the piece was going to be more on the DOL’s Fiduciary rule and how it impacted both insurers, asset managers and broker/dealers. Generally, it seems that independent firms have done better while more those more oriented towards specific products, like in-house mutual funds or annuities have lagged. Broker/dealers have largely shrugged it off, in fact you can see the difference when you compare the returns of the iShares U.S. Insurance ETF (IAK) to the iShares U.S. Broker-Dealers & Securities Exchanges ETF (IAI) after the 2016 election. IAI has strongly outperformed IAK and is positive even in 2018 when the broader financials are struggling. PFG’s asset management team contributed a little more than 22% of the company’s operating revenue in the first quarter, about on par with what it provided in 1Q 17, although that figure grew only by around 10% and is still less than half of what they earn from their retirement income solutions group. Given the fee compression in mutual funds along with the elimination of loads and trailing fees, the opportunities to continue growing that contribution in the future might be more limited.

Hope that helps answer you questions.

[AspiretoRetire]

Thanks for the detailed response. Much food for thought.

[AspiretoRetire]

As a long investor in PFG, I read you piece with interest. However, I see some problems with it and would appreciate any response to the following critique.

First, you assume that investment income should be going up in a rising rate environment, but the value of its bond portfolio has dropped - so maybe there is a hidden problem . . . The answer is obvious. Interest income should be going up, but who in their right mind would expect that the value a portfolio of older bonds would do anything but drop as rates rise? How much does increased interest income offset the decreased value of the portfolio? We do not know.

Also, the bond portfolio losses are unrealized paper losses that matter most if PFG has to sell the bonds. They don’t. That means that the bonds they have will continue generating positive interest income, just not as much as new bonds. That makes the whole issue a big “so what,” not something that affects revenue or cash flow.

Finally, although I have given up trying to predict long-term interest rates, I do think there is no small chance that LT bond prices will recover a bit this fall if the Fed pulls back on its plans to raise rates. That may happen for a number of reasons. If so, the size of the unrealized losses going forward is difficult to predict.

A bigger issue is that PFG is a diversified global financial firm, not just an insurer. The market values them like an insurer, certainly. But how much does the value of the bond portfolio matter to PFG overall? I don’t know from the article.

What am I missing here?

[Mili21]

Based on 3 years Revenue & Net Income growth, just past Thursday, I bought PRU between (over MET).
Also, PRU has a better dividend growth (& prospects) over MET.
BTW, what are your thoughts about AFL?
~V

[ETF Global]

We don't have much of an opinion on Aflac. ETF Global is data provider and ETF research firm so our focus is typically on explaining ETF trends and often the best way to do that is by diving into some of the individual holdings that are driving the trend. In this case, our analysts had noted that insurance funds were trading at low price multiples relative to their own history and certain life insurers were even cheaper which required them to do some digging in the financials.

[User 48475708]

Added to PRU myself, would add to MET too if I had the spare cash

[billjules]

Interesting explanation on the workings/failings of the insurance industry. Interesting that the “fiduciary factor” would outweigh the “rising rate factor.” So I will have to update my sector totals for VYM, QDEF, and RDIV to see how financial they are now. I normally list out their sector percentages (with the help of Morningstar’s excellent sector breakdowns) to make sure I’m not just TOO skewed. (Insert joke here.). Last time VYM and QDEF were over 10% but RDIV was nearly devoid. Suppose I better wait another month until summer rebalancing is done. Good article!

[usiah]

ETFG:

Thanks for the informative analysis.

Recently long PRU.

Retired income/dividend-growth investor