The Sleeping Giant: Value’s Dormant not Dead

Value is a well-studied style factor that has been academically proven to be a driver of excess returns over long periods of time. However, over the course of its long history, value has gone dormant more than once, signaling periods where expensive companies have meaningfully outperformed those that are more attractively priced. We’re in one of these dormant episodes today.

How Dormant?

The most recent value drawdown, which started in the beginning of 2017, is the worst investors have faced in approximately a century. Take the data compiled by Fama and French, two professors who did seminal work on the value factor, constructed by ranking stocks based on book-to-market ratios. Since the start of their dataset in the 1920s, the period from January 2017 to June 2020 makes this period the worst peak to trough drawdown for value on record. Yet, not unlike your favorite sleeping giant tale, many of the worst years associated with value drawdowns (1934, 1980, and the dot-com exuberance of 1999) were subsequently followed by some of the best years for value investing (1936, 1981, and 2000).

Nevertheless, the losses in value are so large— the iShares Edge MSCI USA Value Factor ETF (VLUE) has underperformed the S&P 500 by nearly 10% per year from January 2017 to July 31, 2020¹, that many investors are asking: what’s the best way to invest in value, and even if it still exists? What should investors do?

U.S. Historical drawdowns in Fama-French’s value factor
(HML, for high book-to-market stocks minus low book-to-market stocks, or value minus growth)

Is value still value?

We like to measure value with different variables. Value is always about buying cheap relative to intrinsic value, and intrinsic value can take several forms: book value, cashflow to operations, and forward-looking earnings. Several commentators, including myself, have noted that many companies now possess intangible capital to a greater extent than the past. This is true, but it does not take away from the validity of audited balance sheet information, tangible cashflow, or estimates of forward-looking company circumstances by the best analysts.

In our research, we can track the performance of value constructed using intangible assets relative to a measure of value constructed using traditional earnings yields, finding both to be meaningful but different ways to track value performance.

While there is a role for more active formulations of value to complement traditional value measures with intangible value, the underperformance of value is so pervasive that almost no measure of fundamentals is immune from the value drawdown. Thus, most of the value performance is cyclical. We've recently moved to contraction, and in recoveries, value stocks tend to outperform as the operating efficiencies of these companies allow them to take advantage of improving economic conditions.

Factors tend to have different sleeping schedules

All factors—value included—experience periods of underperformance and dormancy. In fact, bearing these periods of pain is one reason that factors have been rewarded over long periods of time. We can potentially dampen the effect of short-term underperformance of single-factor drawdowns by diversifying across other factors.

Take for example the classic case of value and momentum. Using the same Fama and French dataset, we calculate a -0.42 correlation² between value and momentum premiums going back to the 1920s. This negative correlation is intuitive. All else equal, value companies become deeper value if their prices drop, whereas momentum companies become higher momentum as their prices continue to rise.

Another diversifying factor to value is quality. In a basic dividend discount model, quality is all about the numerator – high quality earnings, while value companies tend to have high discount rates, which operate through the denominator. Consistent with this economic intuition, quality and value have tended to be negatively correlated and this makes the quality factor a potentially powerful complement to existing value exposures.

Diversify across factors

To show the power of diversifying across factors, we analyzed a hypothetical “2-Factor Portfolio” consisting of allocations to value and size which have tended to move in a similar fashion. This portfolio, as expected, expresses a strong overweight to both factors relative to the broad equity market (represented by the orange dash below). However, the portfolio also exhibits strong anti-momentum and anti-quality tilts. Why? Because value tends to be negatively correlated to momentum and quality.

Let’s construct a hypothetical “4-Factor Portfolio” holding value, size, quality, and momentum factors. By doing so, we can maintain the value and size overweight found in the “2-Factor Portfolio”, while also bringing the quality and momentum exposure back in-line with the market. Unsurprisingly, the 4-Factor Portfolio outperformed during this historic drawdown for value over the last 5 years (shown in the table below), supporting the case for factor diversification.

For those who maintain conviction in the value factor, such as we do here at BlackRock, factor diversification will be critically important while waiting for value to finally “wake up.”

Source: BlackRock, Aladdin as of 5/31/2020. Performance data in table as of 6/30/2020. *1,3 and 5 year performance is annualized. The performance quoted represents past performance and does not guarantee future results. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when sold or redeemed, may be worth more or less than the original cost. For individual fund performance, click on the following tickers:  VLUE, SIZE, QUAL, MTUM. Factor Box Score represents raw factor z-scores from the BFRE World Risk Model converted into percentile rankings within the estimation universe. The estimation universe includes: Equity funds denominated in USD that are registered under the Investment Company Act of 1940; Minimum AUM of $25MM; Have at least 90% of its assets covered within the BlackRock BFRE World Risk Model; and For funds with multiple share classes, the largest share class is used. Value, Size, Quality and Momentum represented by iShares MSCI USA Value Factor ETF (VLUE), iShares MSCI USA Size Factor ETF (SIZE), iShares MSCI USA Quality ETF (QUAL), iShares MSCI USA Momentum Factor ETF (MTUM). Orange dash representing the total U.S. market represented by iShares Core S&P Total U.S. Stock Market ETF (ITOT). The 2 Factor Portfolio allocates 50% weight to VLUE and 50% to SIZE, while the 4 Factor Portfolio allocates equal weight to VLUE, SIZE, QUAL and MTUM. This information should not be relied upon as research, investment advice or a recommendation regarding the Funds or any security in particular. This information is strictly for illustrative and educational purposes and is subject to change. This information does not represent the actual current, past or future holdings or portfolio of any BlackRock client.

Looking Ahead

The value giant is sleeping, and it’s hard to forecast exactly when he will awake. I believe the larger risk to investors is being underweight value should a widespread economic recovery take place. So, what can one do to help manage value risk while remaining positioned to capture its potential comeback? Adding allocations to other important factors such as momentum and quality can add diversification and help balance the value factor, rather than giving up on the sleeping giant completely.