Value investing has developed a cult-like following in part because of legendary investor Warren Buffett. Buying $1 worth of assets for 50 cents and selling them for $1.10 is also easy to understand.
In practice, value investors look for stocks trading at low prices relative to cash flow, earnings or other measures of enterprise value. The pitch is simple: buy bargains.
For the devoted, however, staying on the one true path takes courage because value has underperformed for 10 years in the U.S. and for the last five in Canada (see Table 1). Canadian value ETFs cost more than five times those of broad indexes (0.59% versus 0.11% asset-weighted MERs)—so patience has had its price.
Further, Canadian-traded value ETFs all have lower valuations than the S&P/TSX 60 as of June 28, 2019 (see Table 2).
|Table 1 — Annualized returns (period ending June 28, 2019)|
|Canadian indexes in CAD||Style||1 year||5 years||10 years|
|Dow Jones Canada Select Value Index||Value||-1.24%||4.02%||8.45%|
|FTSE RAFI Canada Index||Value||-0.15%||4.38%||8.24%|
|U.S. indexes in USD||Style||1 year||5 years||10 years|
|S&P 500 Value Index||Value||8.67%||7.92%||13.10%|
|Russell 1000 Value Index||Value||8.46%||7.46%||13.19%|
|Table 2 — Value ETFs (period ending June 28, 2019)|
|Canadian value ETFs||Price/|
|Invesco FTSE RAFI Cdn. Fundamental||1.50||14.10||44.8%||21.1%||1.5%|
|iShares Canadian Fundamental||1.50||13.70||44.6%||21.5%||1.5%|
|First Asset Morningstar Canada Value||1.00||9.80||16.6%||16.9%||0%|
|iShares Canadian Value||1.50||12.30||54.9%||13.0%||0%|
|U.S. value ETFs traded in Canada|
|iShares US Fundamental||2.20||16.80||19.2%||8.03%||14.2%|
|First Asset Morningstar US Value||0.90||8.00||14.4%||10.2%||10.7%|
|BMO MSCI USA Value||2.10||13.30||12.7%||4.9%||22.6%|
|Invesco FTSE RAFI US||2.20||17.50||19.2%||8.0%||14.0%|
Why value has underperformed
The typical technology allocation is one reason that value has underperformed. The tech-heavy NASDAQ 100 was cumulatively up 105.5% in Canadian dollars over the last five years, but is underweight in value portfolios (the BMO MSCI USA Value ETF uses a modified benchmark and is an exception). Financial and energy sectors, overweight in value portfolios, underperformed. Although financials (S&P/TSX Capped Financials) outperformed the S&P/TSX 60 cumulatively over five years (42% versus 29%), energy (S&P/TSX Capped Energy) simply performed badly, at -51.4%.
Financials plus energy are 55% of the S&P/TSX 60 versus only 18.1% in the S&P 500, which partly explains Canada underperforming the U.S.
Underweighting technology particularly penalizes Canadian value portfolios. The S&P/TSX 60 has only 6.4% in technology versus 21.8% in the S&P 500, so adding technology to any Canadian portfolio is a good idea (see Advisor.ca/techexposure ).
When interest rates are low, markets discount earnings and cash flows at similarly low rates, giving growth companies expansion potential not available to traditional value stocks. Using the reciprocal of 30-year U.S. Treasury yields, for example, a yield of 8% implies a 12.5 P/E multiple for U.S. stocks. The 2.44% rate on Aug. 1 suggests a P/E multiple of 41—almost double the S&P 500’s trailing 12-month P/E of 21.9, and 67% higher than the 24.6 price/cash flow.
But what rate is sustainable? Three-and-a-half percent is the average 30-year Treasury yield for this expansion, so using a 3.5% to 4.5% range seems reasonable, or a 28 to 33 P/E multiple range. A recession jeopardizes earnings and cash flow, but current P/E multiples (18.9 for the S&P/TSX 60, 21.9 for the S&P 500) reflect this. Although this expansion has sputtered occasionally, long periods of slow growth are not unusual after a major banking crisis. The savings and loan problem in the late 1980s, for example, led to a 10-year economic upswing, so a 28 to 33 P/E multiple range is not unprecedented this far into a cycle. Value may languish a while longer.
Another reason for value’s underperfomance is that valuation of intangibles is increasingly important—but elusive. What is the value of Apple’s brand, or Alphabet’s (Google’s) database? Goodwill plus intangibles on Alphabet’s balance sheet are 10.3% of shareholders’ equity; for Apple, it’s zero. Their “values” are understated. Buffett’s Berkshire Hathaway carries 30.6% of shareholders’ equity as goodwill and intangibles, while Kraft Heinz (more than one-quarter owned by Berkshire) carries 166%. Canadians may love their KD, but Kraft Heinz seems overvalued.
What will make value great again? Banks and energy companies will have to outperform technology. With economies extended and domestic real estate flat, the case for outperforming financials and oil prices is difficult. Technology is more likely to get overextended, but are their values properly reflected?
Value investors might heed their guru’s instructions more carefully. “It’s far better to buy a wonderful company at a fair price, than a fair company at a wonderful price,” Buffett once said. And: “Consistently buy a low-cost S&P 500 index fund.”
Mark Yamada is President of PÜR Investing Inc., a software development firm