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UPDATE: To Buy, Or Not To Buy- An Investors Guide to QE 4

In our RIA Pro article, To Buy, Or Not To Buy- An Investors Guide To QE4, we studied asset performance returns during the first three episodes of QE. We then normalized the data for the duration and amount of QE to project how QE4 might affect various assets.  

With a month of QE4 under our belt, we update you on the pacing of this latest version of extreme monetary policy and review how various assets are performing versus our projections. Further, we share some recent comments from Fed speakers and analyze trading in the Fed Funds market to provide some unique thoughts about the future of QE4.

QE4

Since October 14th, when QE4 was announced by Fed Chairman Jerome Powell, the Fed’s balance sheet has increased by approximately $100 billion. The graph below compares the current weekly balance sheet growth with the initial growth that occurred during the three prior iterations of QE.  

Data Courtesy St. Louis Federal Reserve

As shown above, the Fed is supplying liquidity at a pace greater than QE2 but slightly off the pace of QE 1 and 3. What is not shown is the $190 billion of growth in the Fed’s balance sheet that occurred in the weeks before announcing QE4. When this amount is considered along with the amount shown since October 14th, the current pacing is much larger than the other three instances of QE.

To put this in context, take a step back and consider the circumstances under which QE1 occurred. When the Fed initiated QE1 in November of 2008, markets were plummeting, major financial institutions had already failed with many others on the brink, and the domestic and global economy was broadly in recession. The Fed was trying to stop the worst financial crisis since the Great Depression from worsening.

Today, U.S. equity markets sit at all-time highs, the economic expansion has extended to an all-time record 126 months, unemployment at 3.6% is at levels not seen since the 1960s, and banks are posting record profits.

The introduction of QE4 against this backdrop reveals the possibility that one of two things is occurring, or quite possibly both.

One, there could be or could have been a major bank struggling to borrow or in financial trouble. The Fed, via repo operations and QE, may be providing liquidity either to the institution directly or indirectly via other banks to forestall the ramifications of a potential banking related default.

Two, the markets are struggling to absorb the massive amount of Treasury debt issued since July when Congress extended the debt cap. From August through October 2019, the amount of Treasury debt outstanding grew by $1 trillion. Importantly, foreign entities are now net sellers of Treasury debt, which is worsening the problem. For more read our recent article, Who Is Funding Uncle Sam?

The bottom line is that the Fed has taken massive steps over the last few months to provide liquidity to the financial markets. As we saw in prior QEs, this liquidity distorts financial markets.  

QE4 Projections and Updates

The following table provides the original return projections by asset class as well as performance returns since October 14th.  The rankings are based on projected performance by asset class and total.  

Here are a few takeaways about performance during QE4 thus far:

  • Value is outperforming growth by 1.67% (5.95% vs. 4.28%)
  • There is general uniformity amongst the equity indexes
  • Equity indices have captured at least 50%, and in the case of value and large caps (S&P 100) over 100% of the expected gains, despite being only one-sixth of the way through QE4
  • The sharp variation in sector returns is contradictory to the relatively consistent returns at the index level
  • Discretionary stocks are trading poorly when compared to other sectors and to the expected performance forecast for discretionary stocks
  • Defensive sectors are trading relatively weaker as occurred during prior QE
  • The healthcare sector has been the best performing sector within the S&P as well as versus every index and commodity in the tables
  • The yield curve steepened as expected
  • In the commodity sector, precious metals are weaker, but oil and copper are positive

Are Adjustments to QE4 Coming?

The Fed has recently made public statements that lead us to believe they are concerned with rising debt levels. In particular, a few Fed speakers have noted the sharp rise in corporate and federal debt levels both on an absolute basis and versus earnings and GDP. The increase in leverage is made possible in part by low interest rates and QE. In addition, some Fed speakers over the last year or two have grumbled about higher than normal equity valuations.

It was for these very reasons that in 2013, Jerome Powell voiced concerns about the consequences of asset purchases (QE). To wit: 

“What of the potential costs or risks of the asset purchases? A variety of concerns have been raised over time. With inflation in check, the most important potential risk, in my view, is that of financial instability. One concern is that our policies might drive excessive risk-taking or create bubbles in financial assets or housing.”

Earlier this month, Jerome Powell, in Congressional testimony said:

“The debt is growing faster than the economy. It’s as simple as that. That is by definition unsustainable. And it is growing faster in the United States by a significant margin.”

With more leverage in the financial system and higher valuations in the equity and credit markets, how does Fed Chairman Powell reconcile those comments with where we are today? It further serves to highlight that political expediency has thus far trumped the long-run health of the economy and the financial system.

Based on the Fed’s prior and current warnings about debt and valuations, we believe they are trying to fix funding issues without promoting greater excesses in the financial markets. To thread this needle, they must supply just enough liquidity to restore financing markets to normal but not over stimulate them. This task is much easier said than done due to the markets’ Pavlovian response to QE.

Where the fed funds effective rate sits within the Fed’s target range can be a useful gauge of the over or undersupplying of liquidity. Based on this measure, it appears the Fed is currently oversupplying liquidity as seen in the following chart. For the first time in at least two years, as circled, the effective Fed Funds rate has been consistently below the midpoint of the Fed’s target range.

If the Fed is concerned with debt levels and equity valuations and is comfortable that they have provided sufficient liquidity, might they halt QE4, reduce monthly amounts, or switch to a more flexible model of QE?

We think all of these options are possible.

Any effort to curtail QE will be negative for markets that have been feasting on the additional liquidity. Given the symbiotic relationship between markets and QE, the Fed will be cautious in making changes. As always, the first whisper of change could upset the apple cart.

Summary

Equity markets have been rising on an almost daily basis despite benign economic reports, negative trade and tariff headlines, and Presidential impeachment proceedings, among other worrisome factors. We have little doubt that investors have caught QE fever again, and they are more concerned with the FOMO than fundamentals.

As the fresh round of liquidity provided by the Fed leaks into the markets, it only further advances more misallocation of capital, such as excessive borrowing by zombie companies and borrowing to further fund unproductive stock buybacks. Like dogs drooling at the sound of a ringing bell, most investors expect the bull run to continue. It may, but there is certainly reason for more caution this time around as the contours of the economy and the market are vastly different from prior rounds. Add to this the incoherence of this policy action in light of the record expansion, benign inflation readings, and low unemployment rate and we have more questions about QE4 than feasible answers.

To Buy, Or Not To Buy- An Investors Guide to QE 4

In no sense is this QE” – Jerome Powell

On October 9, 2019, the Federal Reserve announced a resumption of quantitative easing (QE). Fed Chairman Jerome Powell went to great lengths to make sure he characterized the new operation as something different than QE. Like QE 1, 2, and 3, this new action involves a series of large asset purchases of Treasury securities conducted by the Fed. The action is designed to pump liquidity and reserves into the banking system.

Regardless of the nomenclature, what matters to investors is whether this new action will have an effect on asset prices similar to prior rounds of QE. For the remainder of this article, we refer to the latest action as QE 4.

To quantify what a similar effect may mean, we start by examining the performance of various equity indexes, equity sectors, commodities, and yields during the three prior QE operations. We then normalize the data for the duration and amount of QE to project what QE 4 might hold in store for the assets.

Equally important, we present several factors that are unique to QE 4 and may result in different outcomes. While no one has the answers, we hope that the quantitative data and the qualitative commentary we provide arms you with a better appreciation for asset return possibilities during this latest round of QE. 

How QE 1, 2, and 3 affected the markets

The following series of tables, separated by asset class, breaks down price performance for each episode of QE. The first table for each asset class shows the absolute price return for the respective assets along with the maximum and minimum returns from the start of each QE. The smaller table below it normalizes these returns, making them comparable across the three QE operations. To normalize the data, we annualize the respective QE returns and then scale the returns per $100 billion of QE. For instance, if the S&P 500 returned 10% annualized and the Fed bought $500 billion of assets during a particular QE, then the normalized return would be 2% per $100 billion of QE.

Data in the tables are from Bloomberg.  Click on any of the tables to enlarge.

QE 4 potential returns

If we assume that assets will perform similarly under QE 4, we can easily forecast returns using the normalized data from above. The following three tables show these forecasts. Below the tables are rankings by asset class as well as in aggregate. For purposes of this exercise, we assume, based on the Fed’s guidance, that they will purchase $60 billion a month for six months ($360 billion) of U.S. Treasury Bills.

Takeaways

The following list provides a summarization of the tables.

  • Higher volatility and higher beta equity indexes generally outperformed during the first three rounds of QE.
  • Defensive equity sectors underperformed during QE.
  • On average, growth stocks slightly outperformed value stocks during QE. Over the last decade, inclusive of non-QE periods, growth stocks have significantly outperformed value stocks.
  • Longer-term bond yields generally rose while shorter-term yields were flat, resulting in steeper yield curves in all three instances. 
  • Copper, crude oil, and silver outperformed the S&P 500, although the exceptional returns primarily occurred during QE 1 for copper and crude and QE 1 and 2 for Silver.
  • On a normalized basis, Silver’s 10.17% return per $100bn in QE 2, is head and shoulders above all other normalized returns in all three prior instances of QE.
  • In general, assets were at or near their peak returns as QE 1 and 3 ended. During QE 2, a significant percentage of early gains were relinquished before QE ended.
  • QE 2 was much shorter in duration and involved significantly fewer purchases by the Fed.
  • The expected top five performers during QE4 on a normalized basis from highest to lowest are: Silver, S&P 400, Discretionary stocks, S&P 600, and Crude Oil. 
  • Projected returns for QE 4 are about two-thirds lower than the average of prior QE. The lesser expectations are, in large part, a function of our assumption of a smaller size for QE4. If the actual amount of QE 4 is larger than current expectations, the forecasts will rise.

QE, but in a different environment

While it is tempting to use the tables above and assume the future will look like the past, we would be remiss if we didn’t point out that the current environment surrounding QE 4 is different from prior QE periods. The following bullet points highlight some of the more important differences.

  • As currently planned, the Fed will only buy Treasury Bills during QE 4, while the other QE programs included the purchase of both short and long term Treasury securities as well as mortgages backed securities and agency debt. 
  • Fed Funds are currently targeted at 1.75-2.00%, leaving the Fed multiple opportunities to reduce rates during QE 4. In the other instances of QE, the Fed Funds rate was pegged at zero. 
  • QE 4 is intended to provide the banking system needed bank reserves to fill the apparent shortfall evidenced by high overnight repo funding rates in September 2019. Prior instances of QE, especially the second and third programs, supplied banks with truly excess reserves. These excess reserves helped fuel asset prices.
  • Equity valuations are significantly higher today than during QE 1, 2, and 3.
  • The amount of government and corporate debt outstanding is much higher today, especially as compared with the QE 1 and 2 timeframes.
  • Having achieved a record-breaking duration, the current economic expansion is old and best described as “late-cycle”.

Déjà vu all over again?

The prior QE operations helped asset prices for three reasons.

  • The Fed removed a significant amount of securities from the market, which forced investors to buy other assets. Because the securities removed were the least risky available in the market, investors, in general, moved into riskier assets. This had a circular effect pushing investors further and further into riskier assets.
  • QE 4 appears to be providing the banks with needed reserves. Assuming that true excess reserves in the system do not rise sharply, as they did in prior QE, the banks will probably not use these reserves for proprietary trading and investing. 
  • Because the Fed is only purchasing Treasury Bills, the boost of liquidity and reserves is relatively temporary and will only be in the banking system for months, not years or even decades like QE 1, 2, and 3.

Will QE 4 have the same effect on asset prices as QE 1, 2, and 3?

Will the bullish market spirits that persisted during prior episodes of QE emerge again during QE 4?

We do not have the answers, but we caution that this version of QE is different for the reasons pointed out above. That said, QE 4 can certainly morph into something bigger and more akin to prior QE. The Fed can continue this round beyond the second quarter of 2020, an end date they provided in their recent announcement. They can also buy more securities than they currently allude to or extend their purchases to longer maturity Treasuries or both. If the economy stumbles, the Fed will find the justification to expand QE4 into whatever they wish.

The Fed is sensitive to market returns, and while they may not want excessive valuations to keep rising, they will do anything in their power to stop valuations from returning to more normal levels. We do not think investors can blindly buy on QE 4, as the various wrinkles in Fed execution and the environment leave too many unanswered questions. Investors will need to closely follow Fed meetings and Fed speakers for clues on expectations and guidance around QE 4.

The framework above should afford the basis for critical evaluation and prudent decision-making. The main consideration of this analysis is the benchmark it provides for asset prices going forward. Should the market disappoint despite QE 4 that would be a critically important contrarian signal.

Value Your Wealth – Part Six: Fundamental Factors

In this final article of our Value Your Wealth Series we explore four more fundamental factors. The first four articles in the Series researched what are deemed to be the two most important fundamental factors governing relative stock performance – the trade-off between growth and value. In Part Five, we explored how returns fared over time based on companies market cap. Thus far, we have learned that leaning towards value over growth and smaller market caps is historically an investment style that generates positive alpha. However, there are periods such as now, when these trends fail investors.

The last ten years has generally bucked long-standing trends in many factor/return relationships. This doesn’t mean these factors will not provide an edge in the future, but it does mean we need to adapt to what the market is telling us today and prepare for the day when the historical trend reverts to normal.  When they do, there will likely be abundant opportunities for investors to capture significant alpha.

The five prior articles in the Value Your Wealth series are linked below:

Part One: Introduction

Part Two: Quantifying the Value Proposition

Part Three: Sector Analysis

Part Four: Mutual Fund and ETF Analysis

Part Five: Market Cap

Four Factors

In this section, we explore four well-followed factors to understand how they performed in the past and how we might want to use them within our investment decision-making process.

The graphs in this article are based on data from Kenneth French and can be found HERE.  The data encompasses a wide universe of domestic stocks that trade on the NYSE, Amex, and NASDAQ exchanges.

Earnings to Price

Investors betting on companies with a higher ratio of Earnings to Price (E/P), also known as the earnings yield, have historically outperformed investors betting on companies with lower E/P ratios. Such outperformance of companies priced at relatively cheap valuations should be expected over time.

The following chart compares monthly, ten year annually compounded returns for the highest and lowest E/P deciles. 

The graph of E/P is very similar to what we showed for growth versus value. Other than a period in the 1990s and the current period value outperformed growth and the top E/P companies outperformed the bottom ones. This correlation is not surprising as E/P is a key component that help define value and growth.

Investors buying the top ten percent of the cheapest companies, using E/P, have been docked almost 5% annually or about 50% since the recovery following the financial crisis versus those buying the lowest ten percent of companies using this measure.

Given our fundamental faith in mean reversion, we have no doubt this trend will begin to normalize in due time. To help us gauge the potential return differential of an E/P reversion, we calculate future returns based on what would happen if the ten-year return went back to its average in three years. This is what occurred after the tech bust in 2000. In other words, if the ten year annualized compounded return in late 2022 is average (4.81%) what must the relative outperformance of high E/P to low E/P companies be over the next three years? If this occurs by 2022, investors will earn an annual outperformance premium of 28.1% for each of the next three years. The returns increase if the time to reversion is shorter and declines if longer. If normalization occurs in five years the annual returns drop to (only) 14.75%.

Needless to say, picking out fundamentally solid stocks seems like a no-brainer at this point but there is no saying how much longer speculation will rule over value.

Cash Flow to Price

The graph below charts the top ten percent of companies with the largest ratio of cash flow to price and compares it to the lowest ones. Like E/P, cash flow to price is also a component in value and growth analysis.

Not surprisingly, this graph looks a lot like the E/P and value vs. growth graphs. Again, investors have shunned value stocks in favor of speculative entities meaning they are neglecting high quality companies that pay a healthy dividend and instead chasing the high-flying, over-priced “Hollywood” stocks. Also similar to our potential return analysis with E/P, those electing to receive the most cash flows per dollar of share price will be paid handsomely when this factor reverts to normal.

Dividend Yield

Over the last 100 years, using dividend yields to help gain alpha has not been as helpful as value versus growth, market cap, earnings, and cash flows as the chart below shows.

On average, higher dividend stocks have paid a slight premium versus the lowest dividend stocks.While dividend yields are considered a fundamental factor it is also subject to the level of interest rates and competing yields on corporate bonds.If we expect Treasury yield levels to be low in the future then the case for high dividend stocks may be good as investors look for alternative yield as income. The caveat is that if rates decline or even go negative, the dividend yield may be too low to meet investors’ bogeys and they may chase lower dividend stocks that have offered higher price returns.

Momentum

Momentum, in this analysis, is calculated by ranking total returns from the prior ten months for each company and then sorting them. Before we created the graph below, we assumed that favoring momentum stocks would be a dependable investment strategy. Our assumption was correct as judged by the average 10.89% annual outperformance. However, we also would have guessed that the last few years would have been good for such a momentum strategy.

Quite to the contrary, momentum has underperformed since 2009. The last time momentum underperformed, albeit to a much a larger degree, was the Great Depression.

Our initial expectation was based on the significant rise of passive investing which favors those companies exhibiting strong momentum. As share prices rise relative to the average share price, the market cap also rises versus the average share and becomes a bigger part of indexes.  If we took the top 1 or 2% of companies using momentum we think the strategy would have greatly outperformed the lower momentum companies, but when the top and bottom ten percent are included momentum has not recently been a good strategy.

Summary

Factors give investors an informational edge. However, despite long term trends that offer favorable guidance, there are no sure things in investing. The most durable factors that have supplied decades of cycle guidance go through extended periods of unreliability. The reasons for this vary but certainly a speculative environment encouraged by ultra-low and negative interest rates has influence. Investors must recognize when they are in such periods and account for it. More importantly, though, they must also understand that when the trends are inclined to reverse back to normal. The potential for outsized relative gains at such times are large.

At RIA Advisors, Factor analysis is just one of many tools we use to help us manage our portfolios and select investments. We are currently leaning towards value over growth with the belief that the next market correction will see a revival of the value growth trends of the past. That said, we are not jumping into the trade as we also understand that growth may continue to beat value for months or even years to come.

Patience, discipline, and awareness are essential to good investing. 

Value Your Wealth – Part Five: Market Cap

The first four articles in this series focused on what might be the most important pair of fundamental factors – growth and value. Those factors have provided investors long-standing, dependable above-market returns.  Now, we take the series in a different direction and focus on other factors that may also give us a leg up on the market. 

The term “a leg up” is important to clarify. In general, factor-based investing is used to gain positive alpha or performance that is relatively better than the market. While “better” than market returns are nice, investing based on factor analysis should not be the only protection you have when you fear that markets may decline sharply. The combination of factor investing and adjustments to your total equity exposure is a time-trusted recipe to avoid large drawdowns that impair your ability to compound wealth.

We continue this series with a discussion of market capitalization.

The four prior articles in the Value Your Wealth series are linked below:

Part One: Introduction

Part Two: Quantifying the Value Proposition

Part Three: Sector Analysis

Part Four: Mutual Fund and ETF Analysis

Market Cap

Market capitalization, commonly known as market cap, is a simple calculation that returns the current value or size of publicly traded companies. The formula is the number of shares outstanding times the price per share. For example as we wrote this article, Apple has 4.601 billion shares outstanding and Apple’s stock trades at roughly $210 per share. Apple’s market cap is $966.21 billion. 

Most investors, along with those in the financial media, tend to distinguish companies market caps/size by grouping them into three broad tiers – small-cap, mid-cap, and large-cap. Over most periods, stocks in the three categories are well correlated. However, there are periods when they diverge, and we are currently amidst such a deviation. Since September 1, 2018, the price of the Large Cap S&P 500 Index has risen by 4.1%, while the price of the Small Cap S&P 600 Index is down 12.9%.  Deviations in historical relationships, whether short or long-term in nature, can provide investors an opportunity to capitalize on the normalization of the relationship, but timing is everything. 

Historical Relative Performance

The following graphs are based on data from Kenneth French and can be found HERE.  The data encompasses a wide universe of domestic stocks that trade on the NYSE, Amex, and NASDAQ exchanges.

The data set provides returns based on market cap groupings based on deciles. The first graph compares annualized total return and annualized volatility since 1926 of the top three (High) and bottom three (Low) market cap deciles as well as the average of those six deciles. To be clear, a decile is a discrete range of market caps reflecting the stocks in that group. For example, in a portfolio of 100 stocks, decile 1 is the bottom ten stocks, or the smallest ten market cap stocks, decile two is the next ten smallest cap stocks, etc.

The next graph below uses monthly ten year rolling returns to compare total returns of the highest and lowest deciles. This graph is a barometer of the premium that small-cap investing typically delivers to long term investors.

The takeaway from both graphs is that small-cap stocks tend to outperform large-cap stocks more often than not. However, the historical premium does not come without a price. As shown in the first graph, volatility for the lowest size stocks is almost twice that of the largest. If you have a long time horizon and are able and willing to stay invested through volatile periods, small caps should fare better than large caps. 

Small-cap stocks, in general, have high expected growth rates because they are not limited by the constraints that hamper growth at larger companies. Unfortunately, small-cap earnings are more vulnerable to changes in industry trends, consumer preferences, economic conditions, market conditions, and other factors that larger companies are better equipped and diversified to manage. 

Periods of Divergence

The second graph above shows there are only three periods where large caps outperformed small caps stocks since 1926. Those three exceptions, the 1950’s, 1990’s and, the post-financial crisis-era are worth considering in depth.

The 1950s The Nifty Fifty- The end of World War II coupled with a decade of historically low interest rates disproportionately helped larger companies. These firms, many global, benefited most from the efforts to rebuild Europe and partake in the mass suburbanization of America.

The 1990s Tech Boom- With double-digit inflation a distant memory and the swelling technology boom, larger companies that typically benefited most from lower rates, less inflation, and new technologies prospered. While this new technology benefited all companies in one form or another, larger ones had the investment budgets and borrowing capacity to leverage the movement and profit most. 

The 2010’s Post Financial Crisis Era –The current period of large-cap outperformance is unique as economic growth has been prolonged but below average and productivity growth has been negligible. Despite relatively weak economic factors, massive amounts of monetary stimulus has fueled record low corporate borrowing rates, which in turn have fueled stock buybacks. Further, the mass adaptation of passive cap-weighted investment strategies naturally favors companies with large market caps. Circularly, passive investing feeds on itself as indexed ETFs and mutual funds must increasingly allocate more to large caps which grow in size relative to the other holdings.

To reiterate an important point: the current period of outperformance is not based on solid economic fundamentals and resulting corporate earnings growth as in the two prior periods described. This episode is a byproduct of monetary actions.

The graph below highlights the distinction between the current period and the two prior periods where large caps outperformed.  

Summary

Historically, small-cap stocks tend to provide a return premium over large-cap stocks. However, as we pointed out, there are periods where that is not the case. Currently, large-cap stocks are the beneficiaries of overly generous monetary and fiscal policy. We do believe the relationship will return to normal, but that will likely not occur until a bear market begins.

As we wait for a normalization of valuations and traditional relationships that have become so disfigured in this cycle, we consider the current relative valuations on small-cap stocks similar to those we described in value stocks earlier in this series. The time to weight your stock portfolio allocation more heavily toward small-cap opportunities is coming, but every investor must decide on their own or with good counsel from an advisor when to make that adjustment.  When appropriate, a gradual shift to small-cap stocks from large caps depends on an investor’s risk appetite and defensive preference.

More importantly, have a plan in place because when the market does meaningfully correct, the premium small-cap stocks provide will likely help cushion against a stock market correction. 

Value Your Wealth – Part Four: Mutual Fund & ETF Analysis

Parts One through Three of the series are linked below.

Part One: Introduction

Part Two: Quantifying the Value Proposition

Part Three: Sector Analysis

In Part One, the introduction to our Value Your Wealth series, we documented how recent returns for investors focused on growth companies have defied the history books and dwarfed returns of investors focused on value stocks. In particular: “There have only been eight ten-year periods over the last 90 years (total of 90 ten-year periods) when value stocks underperformed growth stocks. Two of these occurred during the Great Depression and one spanned the 1990s leading into the Tech bust of 2001. The other five are recent, representing the years 2014 through 2018.”

In this, the fourth part of the Value Your Wealth series, we focus on growth and value mutual funds and ETFs. Our purpose is to help determine which professional value and growth fund managers are staying true to their stated objectives.

Fund Analysis

A large part of most investor’s investment process starts with the determination of an investment objective. From this starting point, investors can appropriately determine the asset classes and investment strategies that will help them achieve or even exceed their objectives. 

Once an investor decides upon an objective, strategy, and asset class, they must select individual securities or funds. This article focuses singularly on assessing growth and value mutual funds and ETFs. In particular it shows how an investor focused on growth or value can choose funds that are managed properly to meet their goals.

Investors usually key on the following factors when selecting a mutual fund or ETF: 

  • Declared fund strategy (Growth or Value in this case)
  • Prior period returns
  • Fee and expense structure
  • Reputation of the fund family and possibly the manager

These four factors provide valuable information but can be misleading.

For instance, prior returns provide a nice scorecard for the past but can be deceptive. As an example, if we are currently scanning for value funds based on performance, the highest ranking funds will more than likely be those that have leaned most aggressively toward growth stocks. While these funds may seem better, what we believe is more important the fund managers adherence to their objectives.  Given we are looking forward and believe value will outperform growth, we want fund managers that we can trust will stick with value stocks.

It is also important not to shun funds with the highest expenses and/or gravitate towards those with the lowest. We must be willing to pay up, if necessary, to achieve our objectives. For instance, if a fund offers more exposure to value stocks than other comparable value funds, it may be worth the higher fee for said exposure. Conversely, there are many examples where one can gain more exposure to their preferred strategy with cheaper funds. 

Most investors check the fund strategy, but they fail to determine that a fund is being effectively and cost efficiently managed towards their stated strategy. 

We now compare the largest growth and value mutual funds and ETFs to assess which funds offer the most value, so to speak. 

Mutual Fund/ETF Analysis

In order to limit the population of value and growth mutual funds and ETFs to a manageable number, we limited our search to the largest funds within each strategy that had at least 85% exposure to U.S. based companies. We further restricted the population to those funds with a stated strategy of growth or value per Bloomberg.

In prior articles of this series, we have used Bloomberg growth and value factor scores and our own growth and value composite scores. While we would prefer to use our own computations, the large and diverse holdings of the mutual funds and ETFs make it nearly impossible for this exercise. Accordingly, Bloomberg growth and value factor scores provide us the most accurate description of where the respective funds lie on the growth/value spectrum. It is important to note that Bloomberg assigns every fund both a growth and a value score. We consider both scores and not just the score pertinent to growth or value.

We understand most of our readers do not have access to Bloomberg data. As such, we provide a DIY approach for investors to track growth and value exposure amongst mutual funds and ETFs.

Growth and Value Scores

The scatter plot below shows the 54 funds analyzed. Each dot represents a fund and the intersection of its respective growth (x-axis) and value scores (y-axis). The funds most heavily skewed towards value (high value scores and low growth scores) are in the upper left, while heavily growth oriented funds are in the bottom right (high growth score and low value scores).  Information about the funds used in this report and their scores can be found in the tables below the graph. Certain funds are labeled for further discussion.   

A few takeaways:

  • VIVAX (Growth -.60, Value +.37): While this value fund is farthest to the left, there are other funds that offer more value exposure. However, this fund has the lowest growth score among value funds.
  • DFLVX (Growth -.43, Value +.68): This value fund offers an interesting trade off to VIVAX sporting a higher value score but a less negative growth score.
  • AIVSX (Growth +.10, Value -.05): Despite its classification as a value fund, AIVSX has a slight bias towards growth. Not surprisingly, this fund has recently outperformed other value funds but would likely underperform in the event value takes the lead.
  • FDGRX (Growth +.88, Value -.64): This growth fund offers both the highest growth score and lowest value score. For investors looking for an aggressive profile with strong growth exposure and little value exposure, this fund is worth considering.
  • VPMCX (Growth -.04, Value +.16): Despite its classification as a growth fund, VPMCX has a slight bias towards value.
  • In our opinion, the six funds with growth and value scores near zero (+/-.20) in the red box do not currently have a significant growth or strategy orientation, and as such, they are similar to a broad market index like the S&P 500.

It is important to stress that the data represents a snapshot of the fund portfolios for one day. The portfolio managers are always shifting portfolios toward a value or growth bias based on their market views.

 (CLICK on the tables to enlarge)

Data Courtesy Bloomberg

The data above gives us potential funds to meet our strategic needs. However, we also need to consider fees.  

Fees

The scatter plots below isolate growth and value funds based on their respective growth or value score and fees charged.

We circled three groupings of the growth funds to help point out the interaction of fees and growth scores. The four funds in the blue circle have average or above average fees versus other growth funds yet provide a minimal bias towards growth. The yellow circle represents a sweet spot between low fees and a good exposure to growth stocks. Lastly, the red circle shows funds where  heavy exposure to growth comes with above average fees.

This graph circles three groupings of value funds to help point out the interaction of fees and growth scores. The blue circle contains funds with little to no bias towards value. The yellow circle represents a good mix of value and cheap fees. The red circle, our sweet spot in this graph, shows that heavy exposure to value can be had with fees near the group average.

Alpha and Bad Incentives 

Alpha is a measure that calculates how much a portfolio manager, trader, or strategy over or underperforms an index or benchmark. From a career perspective, alpha is what separates good fund managers from average or bad ones.

We mention alpha as we believe the current prolonged outperformance of growth over value is pushing professional fund managers to stray from their stated objectives. As an example, a value based fund manager can add exposure to growth stocks to help beat the value index he or she is measured against.

Adding growth to a value fund may have proven to be alpha positive in the past, but we must concern ourselves with how well the fund manager is adhering to the fund’s objective Simply put, we are trying to find managers that are staying true to their objectives not those who have benefited from a deviation from stated strategy in the past.

It is important to note that positive alpha can be attained by sticking to the stated objective and finding stocks that outperform the index. This is the type of alpha that we seek.

DIY

As discussed, growth and value factors can change for funds based on the whims of the portfolio manager. Therefore, the data provided in this article will not age well. If you do not have access to Bloomberg to track value and growth scores we offer another approach.

Morningstar provides a blunt but effective style analysis tool.  To access it, go to www.morningstar.com and select your favorite fund. Then click on the tab labeled Portfolio and scroll down to Style Details.

The following screen print shows Morningstar’s style analysis for value fund DFLVX.

The box in the top right separates the fund’s holdings by market capitalization and value growth classifications. We can use this data to come up with our own scores. For instance, 59% (46+13) of DFLVX is biased toward value (red circle) while only 6% (5+1) is in growth companies (blue circle). To further demonstrate how a fund compares to its peers, the Value & Growth Measures table on the bottom left, compares key fundamental statistics. As shown by three of the first four valuation ratios, DFLVX has more value stocks than the average for funds with similar objectives.

Summary

The word “Value” in a fund name does not mean the fund takes on a value bias at all times. As investors, we must not rely on naming conventions. This means investors must do some extra homework and seek the funds that are truly investing in a manner consistent with the funds, and ultimately the investor’s, objective.

As we have mentioned, we are at a point in the economic and market cycles where investors should consider slowly rotating towards value stocks. Not only is the style historically out of favor, many of the names within that style are unjustifiably beaten down and due for mean reversion to more favorable levels. We hope this article provides some guidance to ensure that those who heed our advice are actually adding value exposure and not value in name only.

Value Your Wealth – Part Three: Sector Analysis

When we embarked on our Value Your Wealth series, we decided to present it using a top-down approach. In Parts One and Two, we started with basic definitions and broad analysis to help readers better define growth and value investment styles from a fundamental and performance perspective. With this basic but essential knowledge, we now drill down and present investment opportunities based on the two styles of investing.

This article focuses on where the eleven S&P sectors sit on the growth-value spectrum. For those that invest at a sector level, this article provides insight that allows you to gauge your exposure to growth and value better. For those that look at more specialized funds or individual stocks, this research provides a foundation to take that analysis to the next level.

Parts One and Two of the series are linked below.

Part One: Introduction

Part Two: Quantifying the Value Proposition

Sector Analysis

The 505 companies in the S&P 500 are classified into eleven sectors or industry types. While very broad, they help categorize the S&P companies by their main source of revenue. Because there are only eleven sectors used to define thousands of business lines, we must be acutely aware that many S&P 500 companies can easily be classified into several different sectors.

Costco (COST), for instance, is defined by S&P as a consumer staple. While they sell necessities like typical consumer staples companies, they also sell pharmaceuticals (health care), clothes, TVs and cars (discretionary), gasoline (energy), computers (information technology), and they own much of the property (real-estate) upon which their stores sit.

Additionally, there is no such thing as a pure growth or value sector. The sectors are comprised of many individual companies, some of which tend to be more representative of value and others growth.

As we discussed in Part Two, we created a composite growth/value score for each S&P 500 company based on their respective z-scores for six fundamental factors (Price to Sales, Price to Book, Price to Cash Flow, Price to Earnings, Dividend Yield, and Earnings Per Share). We then ranked the composite scores to allow for comparison among companies and to identify each company’s position on the S&P 500 growth-value spectrum. The higher the composite score, the more a company is growth oriented and the more negative the score, the more value-oriented they are.  

The table below summarizes the composite z-scores by sector.  To calculate this, we grouped each company based on its sector classification and weighted each company’s z-score by its market cap. Given that most indexes and ETFs/Mutual funds are market cap weighted, we believe this is the best way to arrange the sector index scores on the growth-value spectrum. 

Data courtesy Bloomberg

As shown, the Financial, Energy, and Utility sectors are the three most heavily weighted towards value.  Real-estate, Information Technology, and Consumer Discretionary represent the highest weighted growth sectors.

While it might be tempting to select sectors based on your growth-value preferences solely using the data in the table, there lies a risk. Some sectors have a large cross-section of both growth and value companies.  Therefore they may not provide you the growth or value that you think you are buying. As an example, we explore the communications sector.

The communications sector (represented by the ETF XLC) is a stark combination of old and new economy stocks. The old economy stocks are traditional media companies such as Verizon, Fox, CBS and News Corp. New economy stocks that depend on newer, cutting edge technologies include companies like Google, Facebook, Twitter, and Trip Advisor. 

As one might expect, the older media companies with more reliable earnings and cash flows are priced at lower valuations and tend to be defined as value stocks by our analysis. Conversely, the new economy companies have much higher valuations, are short on earnings, but come with the prospect of much higher growth potential.

The scatter plot below offers an illustration of the differences between growth, value and market capitalization within the communications sector. Each dot represents the intersection of market capitalization and the composite z-score for each company. The table below the scatter plot provides fundamental and performance data on the top three value and growth companies.

Data courtesy Bloomberg

As shown in the graph, the weighted average z-score (the orange circle) for the communications sector leans towards growth at +0.19. Despite the growth orientation, we deem 58% of the companies in the communications sector as value companies.

The following table compares the weighted average z-score for each S&P sector along with the variance of the underlying companies within the sector and the percentage of companies that are considered value and growth. We use standard deviation on the associated composite z-scores to determine whether companies are close together or far apart on the growth/value spectrum.  The lower the standard deviation, the more similar the companies are in terms of growth or value

Data courtesy Bloomberg

Again here, weightings, market capitalization, and the influence of individual stocks within a sector are important to understand The industrial sector, as shown above, has a score of +0.232, which puts it firmly in growth territory. However, Boeing (BA), due to its large market cap and significant individual growth score skews this sector immensely. Excluding BA, the weighted average composite score of the industrial sector registers as a value sector at -0.07. Again this highlights the importance of understanding where the growth and or value in any particular sector comes from.

Takeaways

The graph below shows the clear outperformance of the three most heavily growth-oriented sectors versus the three most heavily value-oriented. Since the beginning of the post-financial crisis, the three growth companies grew by an average of 480%, almost three times the 166% average of the three value companies.

This analysis provides you a basis to consider your portfolio in a new light. If you think the market has a few more innings left in the current expansion cycle, odds continue to favor a growth-oriented strategy. If you think the economy is late-cycle and the market is topping, shifting towards value may provide much-needed protection.  

While we believe the economic and market cycles are late stage, they have not ended. We have yet to receive a clear signal that value will outperform growth going forward. At RIA Advisors, growth versus value is a daily conversation, whether applied to sector ETF’s, mutual funds or individual stocks.  While we know it’s early, we also know that history has been generous to holders of value, especially after the rare instances when growth outperformed it over a ten-year period as it has recently.