Value may lag growth stocks, but pays off long term

A leading fund manager says value investing’s time will come again despite a widening gap between growth and value stocks.

After building well-diversified portfolios, Dimensional is all about controlling implementation costs.

A near record gap between the performance of growth and value stocks has raised doubts in the investment community about the continuing existence of the so-called “value premium”.

But one of the world’s leading systematic managers is adamant that value’s time will come again.

It appeared to be happening last week when a range of value stocks in the financials, energy, real estate and consumer discretionary sectors in the sharemarket began to surge, with three of the four major banks enjoying their strongest weekly gains on record.

From the viewpoint of Dimensional Fund Advisors, backed up by its strong ties to academia, the unpredictability of the value premium argues for a disciplined and consistent focus on capturing it.

Dimensional Fund is known in the investment community as the standard bearer for systematic, factor-based investing — a style which targets quantifiable company characteristics, such as size, relative price and profitability — to generate higher returns over time.

Even the world’s greatest value managers have been left behind by the crowding into highly priced growth stocks in recent years and there are some persuasive arguments about why value doesn’t make sense any more — such as near-zero interest rates and unprecedented asset buying by central banks, obsolete accounting methods, and the growing importance of intangibles.

But Dimensional’s head of APAC portfolio management, Bhanu Singh, argues that if value investing no longer worked, the economic textbooks would need to be thrown out.

Logic would suggest that an investment with a low price relative to the future expected wealth it’s expected to generate should have a higher expected return than a highly-priced investment, unless of course the market is somehow permanently underestimating its earnings potential.

In the long-term, Australian value (measured by price to book) has beaten growth by 5.49 percentage points per annum.

That’s even better than high-profitability, which has beaten low-profitability by 5.31 per cent per annum, and also better than US value, which has beaten US growth by 3.18 per cent per annum.

In Australia, the value premium has beaten a 3.18 per cent value premium in the US market.

Founded in 1981 in the US as a microcap equities manager, Dimensional Fund Advisors now has over $US500bn ($727bn) of assets under management, $30bn of which is from Australian and New Zealand investors.

Microcaps weren’t really available in an institutional format at the time. “We were the first ones to really invest there — that’s important because trading things that don’t trade very well (in terms of liquidity) is in our DNA,” Singh says. “It comes in handy when we design portfolios.”

Dimensional now does everything from Australian equities, developed market equities, emerging markets equities, fixed income and listed property. It also offers World Allocation balanced funds that combine all those assets into one vehicle.

“One of the things that people might be rightly worried about is that the performance of value-style investing has been pretty poor over the last decade or so,” Singh says. “But while there’s a perception that value does well out of recession, history doesn’t give any clear guide on timing. Yet when the value-growth gap closes, it typically does so very quickly.

“So when you go through these times, the temptation is to say let’s move out of value and switch to growth, but these premiums can move very quickly and the only way to capture them successfully is to stay focused on them and ‘ride out the pain’ in some ways.

“If you understand that the value premium is quite volatile — it’s done this kind of stuff before — and if you hold on during these periods, the gains on the other side are quite significant”

“It doesn’t mean I can tell you when those gains will come, but the past experience has been that when value has underperformed this way, and it has come out of these periods of underperformance, it has been quite significant,” he says.

“The second part is that it’s really quick, so if you’re trying to time it, and say: ‘I’ll get out now and get back in when I think it’s about to turn’ — there’s no reliable way of doing that.”

With the strong comeback in value in recent weeks — led in Australia by banks and energy — Dimensional’s Australian Value strategy is up 19 per cent for the quarter to date, net of fees, compared with a 15 per cent rise in the S&P/ASX 300 index.

Its Australian Small Company strategy is up almost 29 per cent quarter to date with a month to go.

After building well-diversified portfolios, Dimensional is all about controlling implementation costs.

“So we do a lot of things that indices do well, which is well diversified portfolios, a fair bit of transparency in what we hold and what drives returns, but we’re not beholden to a lot of the constraints that indices have, like they have to rebalance at a particular time, and they’ve got to follow a listed index, whereas we kind of define our own fund,” Singh explains.

“One of the things I think we do quite differently to anyone else in the market in the systematic space is that we look at our funds every single day and can rebalance them continuously. What that means is our implementation costs can be significantly lower than competitors in this space. And overall it leads to much better capture because you’re focused on the premium.”