Factor Primer Series: Value

November 14, 2019

Coming back to our series on factor investing (What is a Factor?Small-Cap), this installment will focus on the value factor. As a refresher, we defined factors as a source of excess return that is sensible, persistent over long time periods, pervasive across markets, and cost-effective to capture.

What is the Value Factor? 

Broadly speaking, the value factor represents the excess return derived from investing in stocks that have low values relative to their intrinsic value. In lay terms, it can be identified as the idea of buying low and selling high. Value is known to deliver periods of compressed returns, so it’s important to stay disciplined and stay invested in value stocks.

Where Did Value Investing Come From?

When simplified to the idea of buying low and selling high, value investing has existed since people started trading goods or services. In the context of modern equities markets, it can be traced back to Warren Buffet’s mentor and the father of security analysis, Benjamin Graham. Investors and researchers continued to build on his great ideas, including Eugene Fama and Ken French, who included the value factor in their famous Three-Factor model in 19921.

How Does the Value Factor Provide Excess Returns?

Value’s outperformance can be explained in a number of ways. Oftentimes value companies have recently been the subject of bad news or are in more “boring” industries like utilities. Instead of exciting tech companies that are in the news for groundbreaking technology, value stocks are more likely to consist of companies like Proctor & Gamble, JP Morgan and AT&T. There may also be an element of mean reversion to value investing, as when a stock is out of favor its relative value tends to drop, but over the long run, it tends to revert to its intrinsic value.

How Do You Identify Value Stocks?

There are many ways to identify value stocks, but most rely on using a ratio of a stock’s market price to some accounting measure, some of the more common being price to book, earnings, sales, or cash flow. By sorting stocks by these metrics, you can identify undervalued stocks.

Over long periods of time, systematically sticking to value investing can provide outsized returns. As seen below, in the twenty years ending November 8, 2019, value (represented by the Russell 1000 Value Index) has provided excess returns of 1.29% annualized versus growth stocks (the Russell 1000 Growth Index), even through two recessions (both the Dot-com Bubble and the Lehman Crisis) and one of the longest stretches of growth outperformance in modern market history.

Value has long been an important part of disciplined investors’ portfolios and adding value exposure to a well-diversified portfolio can help generate excess returns over the long haul. BDF has long used value as part of its portfolio, in conjunction with small-cap stocks, momentum and profitability. Next month, we will dig into a factor that often moves in very different directions than value, momentum.

1Fama, Eugene F.; French, Ken R., “The Cross-Section of Expected Stock Returns,” Journal of Finance, Volume 47, June 1992.

Disclosures:
Past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk.  Future performance of any investment or wealth management strategy, including those recommended by Balasa Dinverno Foltz LLC (BDF), may not be profitable, suitable for you, prove successful or equal historical indices.  Historical indices do not reflect the deduction of transaction, custodial or investment management fees, which would diminish results.  Any historical index performance figures are for comparison purposes only and client account holdings will not directly correspond to any such data.  BDF clients must, in writing, advise BDF of personal, financial or investment objective changes and any restrictions desired on BDF’s services so that BDF may re-evaluate its previous recommendations and adjust its investment advisory services.  BDF’s current written disclosure statement discussing advisory services and fees is available for review at www.BDFLLC.com or upon request.

Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this commentary serves as the receipt of, or as a substitute for, personalized investment advice from BDF.