October 2018 Inaugural Portfolio Manager Commentary
A Case for Initiating a Long-Term Investment in Fundamental Value Stocks
The patience and conviction of classic value investors have been severely tested over the last nine to ten years by the investment style’s protracted underperformance in comparison to growth investing. Since the start of 2009, the Russell 1000 Value Index has lagged the Russell 1000 Growth Index by about 160% cumulatively. The Russell 1000 Value Index has underperformed the Russell 1000 Growth Index by about 17% over the past 12 months and 13% year-to-date (YTD). Within the S&P 500, the S&P 500 Growth Index has outperformed its value counterpart by approximately 138% on a cumulative basis since the start of 2009, and by about 16% over the last 12 months and 14% YTD.
The near-decade-long underperformance of value relative to growth has caused the valuation gap between these respective styles to move toward peak levels not seen since the late 1990s near the end of bubble in telecom and tech stocks (Figure 1). This level of outperformance by growth is statistically rare, now more than two standard deviations above the mean. While large disparities in these multiples can often persist for some time, it is also true that the last such instance of such a pronounced valuation gap did not last very long.
Source: Factset Research; Data represents weighted harmonic average P/Bk and trailing quarters’ P/E of the top half of the S&P 500 constituents minus the bottom half for each period.Prior year annual book values and earnings were used in the event that quarterly data were not available. Companies with available quarterly book value and earnings per share declined significantly for periods before 1998 and 1999, respectively.
The past decade also represents a departure from the long-term record. Over the last 50 years, the value style has outperformed the growth style about 57% of the time, and by an average annual amount of 2.7%, (Figure 2). That incremental outperformance, compounded over long periods of time, can yield large differences in the terminal value of investments. In the world of investing, which is ultimately a game of inches, that “little” 2.7% delta is equivalent to about a 300% increase in wealth over the 50 year period, or $4 of net worth for each $1 initially invested. This is why we continue to view value-based investing as a time-tested strategy, notwithstanding the current anomalous period.
Source: Fama and French
If history is a guide, the present valuation gap between value and growth should mean-revert over time. While the exact timing for such a reversion is difficult to know, we see at least three potential catalysts for such a shift. First, a return to value outperformance has occurred in the past when the growth-to-value gap in valuations has reached extremes. In fact, value-based investing could not have outperformed over the last 50+ years if this were untrue.
Second, much of the outperformance of growth has been driven by a relatively small subset of technology franchises and Internet platforms, which are highly disruptive to existing business models. Companies such as Amazon, Google, Facebook and others enjoy substantial competitive advantages—often operating in winner-take-all markets—and are taking massive share from threatened, traditional players. Amid this creative destruction, these innovative firms are posting growth rates and investment returns despite their already large size which haven’t been observed since the emergence of the industrial revolution and the subsequent rise of Standard Oil Company. While we understand this powerful dynamic, we also recognize that trees do not grow to the sky. Indeed, the growth rates of these new titans are already slowing, while the regulatory and other threats to their business models appear to be emerging. In this context, the tailwinds for many of these disruptive franchises likely cannot strengthen further but will probably diminish – a development which lessens the relative attractiveness of growth funds, which have profited handsomely from the rise of these disruptors.
Finally, a third catalyst favoring value are the changes now occurring in global and domestic macroeconomic conditions, as well as the concomitant shifts in monetary policy. Specifically, we expect greater inflation and higher interest rates. Both phenomena tend to compress valuation multiples, such as price-to-earnings, while boosting the earnings of many value-oriented sectors and stocks.
To understand this third catalyst, we first need to understand how stock pricing and valuations arrived at this point. In response to the credit meltdown and the “Great Recession,” central banks embarked on extraordinarily loose monetary policy. Such a highly accommodative policy shift, orchestrated through a combination of central bank balance sheet expansion, otherwise known as quantitative easing (QE), as well as reductions in official short-term interest rates led to the massive and protracted outperformance of growth over value. This is clearly visible in the correlation between the timing of QE and outperformance of growth over value (Figure 3).
Note: Value and Growth based on Fama French portfolios; Source: Bank of America Merrill Lynch US Equity & US Quant Strategy, Federal Reserve Board, Ibbotson, Bloomberg, S&P, and Russell
It is our belief that the uncommon degree of outperformance of growth over value is explained in part by the unique magnitude and duration of the epic QE program. However, the highly accommodative stance of central banks is now reversing, as central banks collectively attempt to shift toward a neutral stance on a global basis. The Federal Reserve has already started to tighten, and Europe and Japan have ceased easing. Moreover, the increasing supply of U.S. Treasuries, due to deficit spending combined with a reduction in demand (i.e., cessation of central bank debt purchases), amount to the reverse of QE: quantitative tightening (QT). We believe that QT is already putting upward pressure on interest rates. We expect global monetary conditions to become increasingly restrictive, as central banks work to shrink their balance sheets, governments issue more debt, and interest rates continue rising.
Prior periods of tightening have occurred with concurrent periods of significant outperformance of value over growth. Value stocks have outperformed growth stocks about two-thirds of the time during QT (lower left table, Figure 3). Moreover, the cumulative outperformance of value over growth across those tightening periods was more than 10%.
We believe that the concurrence of monetary tightening and value outperformance is no mere coincidence. During the latter stages of recovery, growth broadens across much of the economy. This broadening represents an increase in the number of companies experiencing earnings growth, thereby making such “growth” opportunities less scarce. In such an environment, the multiple paid for growth companies declines, enabling value to outperform growth.
Another aspect of this dynamic is the relationship between interest rates and equity valuation multiples. The inverse of the most widely cited of those multiples, the price-to-earnings ratio, is earnings-to-price, i.e., the earnings yield of a stock. While such equity earnings are not contractually mandated as in the case of bonds, it is nonetheless true that rising interest rates do indeed increase investors’ return expectations – as the opportunity cost for equity earnings yields are those offered by bonds. Thus, the rising rates can put downward pressure on equity multiples and, by extension, stock prices in a similar way to the downward pressure exerted on bond prices, although the correlation is obviously not so mathematically tight in the case of stocks and rates. Given the unprecedented level of easing and the record-low levels of interest rates that have prevailed over the last decade, it was logical for equity valuation multiples to increase to record levels, thereby helping to drive a substantial rise in global stock markets. However, it also would seem reasonable to expect that a reversal of these monetary conditions would usher in a period of rising interest rates and declining equity valuation multiples, pressuring global equities. In such an environment, we would view the higher-multiple growth stocks to be particularly vulnerable.
One other issue to consider is the greater predominance of passive investment vehicles within the market during the present cycle (Figure 4). Passives tend to boost the momentum of those investment styles and strategies that are currently in favor. We believe that they have magnified the level of outperformance of growth over value during the last 9-10 years. However, if value begins to outperform growth, we would expect to see passive investment vehicles begin to confer momentum to those value strategies, thereby increasing the speed and magnitude of any prospective shift in relative performance of value versus growth.
Source: Factset Research
Given all of this, we believe that investors should position themselves during this early stage of QT by gaining greater exposure to value-based strategies. We have constructed the DoubleLine Value ETF (DBLV) to help investors with this positioning. DBLV follows a value-based investment strategy, and thus should benefit from higher inflation and tightening monetary conditions.
The two industries with disproportionate exposures to value stocks are the financials and energy sectors (Figure 5). In contrast, consumer discretionary, consumer staples, industrials and information technology mainly comprise growth names. Given the prior discussion around the anticipated impact of a tightening macroeconomic environment on the relative performance of growth and value, it should be clear that we would expect to see better relative performance of financials and energy companies amid higher inflation and interest rates. Meanwhile, the higher valuation multiples associated with many consumer discretionary, consumer staples and technology names could make them relatively more vulnerable to a downward re-rating of equity valuation multiples.
Source: Factset Research and S&P
It is important to point out that sectoral exposure to growth versus value stocks is not definitive, since there are firms with above-average growth prospects within the financials and energy sectors and others with below-average valuation multiples within the consumer discretionary or technology areas. Moreover, there are select growth stocks across sectors which can continue to post above-average earnings growth, offsetting valuation multiple compression from higher interest rates. In addition, we do not expect all sectors with meaningful exposure to value stocks to outperform in a tightening macro environment. While the utilities, real estate and traditional telecommunication services sectors* also have relatively lower valuation multiples, the unique characteristics of many of these companies likely make them more vulnerable to a bond-like adverse reaction as interest rates rise.
*Telecom was recently recast into communication services, broadening the sector by including old and new media companies.
Source: DoubleLine, as of 9/30/2018
The positioning of DBLV reflects our expectation of the emergence of a more favorable macroeconomic environment for the value-oriented sectors highlighted earlier. It also highlights our recognition that we are in the early stages of such a transition and that the exact timing of such a shift is difficult to predict. Beyond this, the sector weights are a function of the collection of attractive investments that our rigorous, bottom-up research seeks to uncover. The sector over- and under-weights of the DBLV portfolio are highlighted in Figure 6.
We are moderately overweight the financials and energy sectors based upon the foregoing analysis. We expect those weights to grow larger over time if and when the macroeconomic environment becomes more favorable. Within the financial sector, we favor banks with a stable depositor funding base and higher sensitivity to interest rate hikes, along with select life insurance companies. In energy, we are tilted more toward U.S.-centric shale oil producers and oil service providers than the benchmark**, given their relatively low production cost and lower project risks versus other areas within the sector
The portfolio is also overweight the consumer discretionary, information technology, healthcare and communications services sectors, reflecting what we see as attractive investment opportunities represented by particular companies within these highly varied segments. We are slightly underweight the materials and industrials sectors, largely based upon the relative attractiveness of companies found in those segments versus others within the broader market. We are underweight the consumer staples, real estate and utilities sectors given the relatively high valuation of these segments in light of the adverse risks facing most of these names if inflation and interest rates continue to rise at an accelerating rate. We also are choosing to hold excess cash as dry powder at the moment.
Skillful stock picking requires an examination of individual firms on a case-by-case basis and a focus on the fundamentals of the underlying businesses. Our equity research process, which entails such an analysis, is the primary driver behind our portfolio holdings and weights. We evaluate each investment as bottom-up investors, taking into account the impact of macro and industry factors secondarily and only to the extent that they meaningfully impact those underlying business fundamentals. That said, we do believe that macro factors will continue to exert a disproportionate impact on the equity markets. This is why we have treated some of these top-down issues in this inaugural commentary. The portfolio characteristics and top-ten allocations can be seen in Figure 7.
**The benchmark for DBLV is the Russell 1000 Value Index.
Source: DoubleLine, as of 9/30/2018
The DBLV ETF is being launched with 49 names, which is at the high end of our target range. A list of the top-ten initial portfolio weights is presented in Figure 7. These starting allocations comply with portfolio guidelines in terms of stock and sector initial weight limits. The weighted average market capitalization of the portfolio skews above that of its benchmark, the Russell 1000 Value Index. Meanwhile, the portfolio’s active share versus that index—a measure of the extent to which the portfolio deviates from its benchmark—exceeds 75% and, therefore, is relatively high versus average levels for mutual funds. We plan to run the portfolio with high active share and low turnover on a consistent basis.
We are pleased to be managing the AdvisorShares DoubleLine Value Equity ETF, and we look forward to continuing the dialogue in the months ahead.
AdvisorShares DoubleLine Value Equity ETF (DBLV) Co-Portfolio Managers
|Emidio Checcone||Brian Ear|