Commentary by Viktor Nossek, Head of Investment and Product Analytics, Vanguard Europe
As global stock markets rebounded from the initial shock of Covid-19 in the first quarter of 2020, so-called “growth” stocks—spearheaded by large technology groups—soared to ever-higher price-to-value multiples.
With value stocks now starting to outperform their growth counterparts—a trend that our research suggests could persist over the next decade—is allocating to value indices the only way to exploit this rotation? Or is there an alternative approach to effectively capture the value factor that can help avoid some of the unintended consequences of traditional value strategies?
Even before the advent of the coronavirus crisis, technology-led growth stocks had been riding high relative to their value counterparts in the low-inflation environment that had prevailed since the 2008 global financial crisis. Then came Covid-19 and, fuelled in part by the trend towards increased digitalisation during the pandemic, technology stocks in particular have risen to price-to-book value multiples not seen since around the time of the peak of the dot-com bubble.
And even after taking into account the surge in performance of value stocks in the early months of 2021, the valuation premium of growth and technology stocks over value equities is nearing extremes not seen in a quarter of a century.
Technology-led markets trading at high multiples
Past performance is not a reliable indicator of future results.
Source: Bloomberg. Data from 1 January 1995 to 30 April 2021. Monthly observations. Valuation premium measured as the difference between MSCI World Information Technology and MSCI World Value price to book ratios. MSCI World Information Technology = MSCI World Information Technology Index; MSCI World Value = MSCI World Enhanced Value Index. Price to book multiples are calculated from index members' stock price and book value per share, in USD terms.
As with previous cycles, growth’s recent outperformance has likely sown the seeds for value’s resurgence on a relative basis. Now, amid a broadening economic recovery, it’s perhaps not surprising that many investors will be looking to position client portfolios to benefit from this cyclical rotation.
The lure of value strategies is that some value stocks can offer the potential for attractive risk-adjusted returns at low (relative to their growth counterparts) price-to-value multiples.
However, they can also expose investors to “value traps”, where a company’s low valuations are underpinned by weak fundamentals. In other words, while some value stocks can offer investors latent returns, others may be priced by the market consensus at cheap valuations with good reason. Viewed through the lens of the Fama–French five-factor model, value traps are those stocks whose excess returns are sensitive to the value factor (that is, the excess returns of cheap over expensive stocks) but not to the profitability factor (the excess returns of high- over low-profitability stocks).
The chart below decomposes the returns of two indices—the MSCI World Enhanced Value Index and the FTSE All World High Dividend Yield Index—over a 13-year period. As one would expect, the value strategy loads to the value factor – but as the chart shows, it has a minimal loading to the profitability factor. This suggests that the index’s sensitivity tilts towards stocks with overall low profitability.
Fama & French factor loadings - high-dividend and value factor exposures
Past performance is not a reliable indicator of future results.
Source: Bloomberg, Fama & French Data Library, Vanguard. Data from 1 May 2008 to 31 March 2021, using monthly data and the longest joint data history available for the indices shown. FTSE All-World High Dividend Yield = FTSE All World High Dividend Yield Index; MSCI World Enhanced Value = MSCI World Enhanced Value Index. Both indices are net returns in USD. Factor loadings are regression beta coefficients to Fama & French factor return premiums. Please go to Fama & French Data Library for more information about Fama & French factor definitions and calculation methodology.
Certain high-dividend exposures—such as the FTSE All-World High Dividend Yield Index—on the other hand, not only capture the value factor (albeit with slightly less sensitivity than value strategies); they also score highly on the profitability factor, offering greater exposure to companies with robust profitability. By tilting away from “deep-value” propositions that are typically included in traditional value strategies, high-dividend strategies can help investors to mitigate the risk of value traps.
One way that high-dividend strategies can achieve this is through their index construction methodology. Market-cap-weighted high-dividend indices, such as the FTSE All-World High Dividend Yield Index, screen constituents by dividend yield then weight them according to market capitalisation. Weighting by market cap tends to favour more profitable companies, which score strongly on the profitability factor.
Many value indices, by contrast, weight constituents by value factor scores and don’t take market capitalisation into account, which can lead to low profitability factor loadings.
From a portfolio positioning perspective, using high-dividend exposures to access value stocks can help investors avoid certain unintended sector biases.
Given the dominance of big tech companies in the growth universe, many investors might expect the IT sector to represent a relatively small share of the value landscape. However, this is not reflected in all value indices, and it highlights why carrying out thorough due diligence of the methodology and underlying holdings of any index is crucial.
For example, as the chart shows, the MSCI World Enhanced Value Index has a weighting of 21% to the IT sector. The FTSE All World High Dividend Yield Index, in comparison, has an IT sector weighting of around half of this, at 11%.
The financial sector is another case in point. Amid the prospect of rising interest rates, steepening yield curves and heightened inflation risks, many investors might view financials as a lynchpin of a value portfolio which should thrive in such an environment.
But again, the underlying holdings of some value strategies might come as a surprise to some. As of the end of April this year, financials made up around 14% of the MSCI World Enhanced Value Index, versus more than 25% of the FTSE All World High Dividend Yield Index.
Sector weights – high-dividend and value factor exposures
Source: Bloomberg. Data as at 30 April 2021.
Investors seeking exposure to the value factor should also consider the diversification benefits of the indices they choose. For example, the FTSE All World High Dividend Yield Index comprises more than 1,640 securities, more than four times the breadth of the MSCI World Enhanced Value Index, which is made up of just 4001. Owing to the greater diversification, high-dividend indices may also offer lower volatility than traditional value strategies too2.
As investors consider the contrasting fortunes of growth versus value, they should also think about how they gain exposure to these factors. High-dividend yield strategies can be much more than just a source of income. They can also offer diversified exposures that capture the value factor with lower volatility than traditional value strategies while helping to mitigate value traps.
1 Source: Bloomberg. The FTSE All World High Dividend Yield Index comprised 1,642 constituents and the MSCI World Enhanced Value index comprised 400 constituents as at 31 May 2021.
2 Source: Bloomberg. Data from 7 October 2014 to 30 April 2021. The FTSE All World High Dividend Yield Index had an annualised volatility of 14.4% while the MSCI World Enhanced Value Index had an annualised volatility of 15.2% during the period.
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