Market Commentary July 2018 State Street Global Equity Fund Why Smart Equity Investors Continue to Look for Value Ample evidence demonstrates the long-term efficacy of value investing. As with any investment, however, Value has sometimes experienced cyclicality. At this relatively low point in the cycle, applying a robust definition of Value, rather than relying on one or two individual measures, can help investors to fully capture the Value premium over the long term. Olivia Engel, CFA Chief Investment Officer Active Quantitative Equities On the surface, value investing seems simple: it s about choosing stocks that are trading for less than their intrinsic or true value. After all, who wouldn t agree to a deal where one pays less than the market price? Bargains are good! That s why Value has become one of the most popular philosophical approaches to active equity investing. Born in the 1920s from Benjamin Graham and David Dodd s teachings at Columbia Business School, the Value premium over the long term has been extensively documented. In the short run, the efficacy of the Value theme experiences cyclicality like any investment. Viewed through a shorter-term lens, we re currently at a relatively low point in the Valueperformance cycle. Recent performance of new-economy growth companies, which trade on increasingly large multiples of their trailing or estimated forward earnings, has led to underperformance of many Value strategies since the end of 2016. With that backdrop in mind, in this commentary, we ll investigate some of the questions that reasonable investors might be asking themselves about Value right now. Does Value investing still make sense? If so, how can investors make the most of the Value theme through this down cycle in pursuit of their longer-term objectives?
Assessing Value over the long term Using a systematic approach to valuation, we can develop a broad view on how Value as a theme has worked over time. In their three-factor model, Eugene Fama and Ken French defined Value using three key metrics or sub-factors : the book to market ratio, cash flow to price ratio, and earnings to price ratio. Drawing on the Ken French Data Library s extensive data on equity returns dating back to June 1926 (for book to market) and to June 1951 (for cash flow to price and earnings to price), we calculated compounded annual returns for each sub-factor, measured by equal-weighted quintile spreads: Subfactor Time horizon Compounded annual returns Book to market 1926 2018 10.8% Cash flow to price 1951 2018 7.4% Earnings to price 1951 2018 6.3% (See also Figure 1.) This analysis confirms that the Value theme has yielded a distinct premium over time. Figure 1. Index of quintile-spread returns by Value sub-factor for stocks listed on the NYSE, AMEX, and NASDAQ, June 1926 through May 2018, Center for Research in Security Prices data Historical data confirms that the Value theme has yielded a distinct premium over time. Legend Book to Market Cash Flow to Price Earnings to Price Source: http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html as at 31 May 2018
Of course, long-term efficacy and short-term performance are not the same thing. As with any investment, the Value theme has experienced cyclicality at various points in time. We re currently at a relatively low point in the cycle. As we can see in Figure 2, Value has been underperforming its long-term average returns for nearly eight years now. This is not the first time this has occurred. In the aftermath of World War II when the market was returning about 20% per year Value experienced a similar downturn, consistently registering below-average performance for almost 17 years, from 1953 to 1970. (We ve focused here on the book-to-market sub-factor because it s been measured since 1926, allowing us to make our observations over a longer period.) We expect the current cycle to reverse in less time compared with the post-war downturn. Following the Global Financial Crisis, central banks in developed regions pursued aggressive monetary easing tactics to provide liquidity. This, in turn, inflated asset prices to the levels we re now observing in the second-longest equities bull market in history. The US central bank is now actively reducing its balance sheet and increasing rates. Other central banks are likely to follow. Rising rates have a positive effect on the Value premium. Since a large component of growth stocks valuation depends on the present value of future cash flows, steadily rising rates lead to progressively lower growth-stock valuations. In contrast, Value stocks are less susceptible to increasing rates, so a rising interest-rate environment would help to bring the Value premium back to long-term averages. With this in mind, rather than abandon the Value theme until its performance improves, we believe that this is exactly the time to adhere firmly to the time-tested principles of Value investing and not to give into irrational exuberance. At the same time, it s important to be discerning when investing in Value, with a focus not only on minimizing downside risk, but also on positioning well to take advantage of the cyclical upturn. Figure 2. 10-year rolling annualized quintile spread returns for US equities listed on NYSE, AMEX, and NASDAQ As with any investment, the performance of the value theme experiences cyclicality. Legend Book to Market Average Source: http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html
Making the most of Value investing at a low point in the cycle Defining and measuring Value. In order to take full advantage of the Value theme, it s important to define Value using a more comprehensive set of value-related measurements. When we broaden the investable universe and the definition of Value beyond the conventional three-sub-factor model we ve referred to so far, we discover some interesting trends. In Figure 3, we have used a number of wellknown Value ratios 1 to create equally weighted long-short portfolios, long the best quintile of companies on each metric, and short the worst quintile. Interestingly, although all ratios have historically experienced strong long-term returns, recent performance indicates an increasing dispersion in performance. Ratios such as dividend yield and price to cash flow have generated negative returns recently, while price to earnings (both forward and trailing) and price to sales are still providing a positive premium. (The average documented in Figure 3 is a simple average of the performance of each of the seven metrics over each time period.) Figure 3. Average annual, quintile spread returns for value metrics, MSCI ACWI universe, between December 1997 and May 2018 ( Long Term ) and December 2016 and May 2018 ( Recent ) Recent performance of well-known Value metrics suggests increasing dispersion in their performance. Legend Long Term Recent Source: MSCI, Factset, State Street Global Advisors as of May 31, 2018. Using a robust definition of Value, rather than relying on one or two individual measures, can help investors to fully capture the Value premium especially at a time when some individual definitions of value exhibit little to negative correlation. Uncovering Value opportunities. Applying our broad definition of value in the form of a simple average of all seven metrics cited in Figure 3 reveals where Value investing opportunities may be found by sector. Examining the performance of an average of our seven value metrics by GICS 2 sector, we see negatively correlated performance from December 2016 to May 2018.Contrary to popular belief, however, there are sectors 1 The metrics referenced in this analysis are: dividend yield; price-to-cash flow ratio ( P/CF ); enterprise-value-to-ebitda (earnings before interest, taxes, depreciation, and amortization) ratio ( EV/EBITDA ); price-to-book ratio; price-to-earnings ratio ( P/E ); price-to-forward-earnings ratio ( P/FE ); and price-tosales ratio ( P/Sales ). 2 Global Industry Classification Standard
such as energy and materials where Value investors are generating meaningful excess returns by using a broad measure of value. (See Figure 4.) Figure 4. Average monthly, quintile-spread returns by GICS sector for a composite Value factor, December 2016 to May 2018 A robust definition of Value reveals sector-level performance dispersion for Value in the current cycle. Source: MSCI, Factset, State Street Global Advisors as of May 31, 2018. The performance of the Value theme since December 2016 has been markedly different across sectors. Value has continued to work within the Real Estate and resources sectors. In the technology and consumer segments, we have seen a meaningful decline in the efficacy of the Value theme, driven by the outperformance of the most expensive tech and consumer stocks, including the FANGs. 3 At the regional level, comparing the average annual spread returns over the long term (from December 1997 to May 2018) with recent performance (December 2016 to May 2018) for our composite factor reveals a sharp reversal in performance of Value since late 2016 in most regions, with the notable exception of Europe. (See Figure 5.) This difference might be explained somewhat by the sector concentration in each market. Japan and the United States both have a high weight to technology and consumer discretionary stocks, where value strategies have performed least well. In contrast, Europe has a much smaller weight to technology compared with Japan and the US. Even so, this analysis shows that Value-minded investors can find pockets of relatively strong Value performance, even at this point in the cycle. 3 Facebook, Amazon, Netflix and Alphabet s Google. This information should not be considered a recommendation to invest in a particular sector or to buy or sell any security shown. It is not known whether the sectors or securities shown will be profitable in the future.
Figure 2. Average annual, quintile-spread returns for value metrics, by region, between December 1997 and May 2018 ( Long Term ) and December 2016 and May 2018 ( Recent ) Average annual, quintile-spread returns for value metrics, by region, between December 1997 and May 2018 ( Long Term ) and December 2016 and May 2018 ( Recent ) Legend Long Term Recent Source: MSCI, Factset, State Street Global Advisors as of May 31, 2018. The bottom line The Value theme is a time-tested approach to equity investing, which has yielded impressive long-term results that few investors can afford to ignore. Like any investment, Value is subject to cyclicality. During down periods in the cycle, investors can improve their long-term prospects for success by being discerning as they continue to invest in Value stocks. To that end, we believe that a robust and multi-dimensional approach to Value is essential for investors who seek to reap the benefits of Value investing over the long term. Over the years, our research in Active Quantitative Equity has yielded an ever-more comprehensive and nuanced approach to equity valuation by market segment and business type. These nuances run broad and deep, from making adjustments for research and development expenditure in research-intensive industries, to taking into account the importance of dividend yield for Australian equities, to considering capital management by companies in the form of share buybacks. Over time, these nuances can make a meaningful difference to the performance of broad Value strategies over time.
Portfolio Positioning and Performance 4 During June, the State Street Global Equity Fund underperformed the benchmark on a gross and net of fees basis. The global developed equity market was mixed during the month as trade tensions between the United States and its major trading partners continued to escalate. Macroeconomic concerns continued to weigh on European markets; with the fragility of the EU increasing (although economic activity indicators remained robust). From a sector perspective, negative stock selection within Consumer Discretionary and Financials were the key detractors from relative performance. On the other hand, good stock picking within Utilities and IT were the main contributors. During the past year, good stock picking within Real Estate and Staples were more than offset by our relatively lower exposure to IT and negative stock selection within Discretionary. The most notable change to the fund over the past 12 months was our decreasing exposure to Health Care as we are finding superior risk/return opportunities in other cyclical sectors such as IT and Energy. 4 As at 31 May 2018. This information should not be considered a recommendation to buy or sell any security or sector shown. It is not known whether the securities or sectors shown will be profitable in the future.
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