Value factor... now you see me, now you don't ...and you won't(?)
Investors with exposure to factor based strategies are likely to have value (or growth, being the opposite so we will only refer to value here) as their main allocation. Volumes of studies confirm the existence and persistence of value (and other risk premia) over the long-term giving investors comfort that well established and researched factors will deliver much needed excess returns. In this note we aim to illustrate that value, as commonly defined, is likely to continue to underperform due to structural aspects.
Be patient…
Despite long-term evidence of excess returns associated with value stocks, value strategies have delivered disappointing outcomes for investors with roughly a decade of underperformance. The general suggestion seems to be that investors should be patient, have long-term horizons and that factors can underperform for long periods of time. This is of course true with factor strategies as with any other allocation. However, as value seems to have underperformed only three times since 1985 and then typically for short periods, a decade of continued underperformance seems a long time even for the most patient of investors.
Attempts to resolve the issue of factor underperformance, particularly in multi-factor structures, have mostly been to fine tune factors or concentrate factors or dynamically weigh factors or to contort factors in other ways in search of positive outcomes (while warning others of risks of data-mining…). Throughout all this value has remained an underperforming exposure. The message to investors continues to be uniformly the same; have patience and long investment horizons. We believe in the case of common value strategies time may not be on investors' side.
Other parts of the puzzle
Although factor studies typically cover long time periods and various market conditions, very few go beyond 30 years (certainly a long period to consider). This is important as despite economic cycles and changes in sector composition and rotation, the past three decades have seen a general and significant yield compression, from a level of ca 15% in mid-80's to near zero post GFC. This has meant that firms’ asset values have been rising partly as a result of general re-pricing conditions. This is certainly true for real assets but also holds generally for all assets. These favorable market conditions have also allowed financial flexibility to firms possibly when flexibility was needed the most. Underperforming or value companies could still re-leverage as the value of their assets rose despite perhaps experiencing operating and earnings weakness. All things being equal ongoing re-leveraging of assets to lower cost debt creates equity value and at the same time higher equity risk due to higher leverage should be compensated with higher returns. However, in the post GFC era and near zero interest rates market conditions have changed in a fundamental way and the potential for any further asset re-pricing is limited also restricting financial flexibility for underperforming firms. Value, as commonly defined, may have arrived at the end of a three-decade-plus long asset re-pricing wave.
Compensation for leverage
So why is leverage important. Looking more closely, research has pointed out that the Fama-French model does not comply with Miller-Modigliani proposition for cost of capital as it does not adjust for firm leverage. Higher leverage means higher risk to equity and therefore requires higher returns. Some researchers have shown that sensitivity coefficients in Fama-French models can be adjusted to resolve for this and others have included a separate leverage factor as an extension from Fama-French. And although some academics advocate that additional factors should not be considered as part of factor investing, it is worth pointing out that the leverage factor too is academically valid in theory and verified as significant in applied research.
The chart below illustrates the difference in leverage for value and growth stocks in the US. It highlights the significant and persistent shift in leverage in favor of growth stocks (i.e. higher leverage) in the past decade.
The shift in relative performance and excess returns between value and growth seems structural and importantly a direct result of leverage and how it flows to firms. Over the past three decades value companies have had lower earnings yields but have been able to sustain slightly higher leverage ratios likely as a result of rising asset values. Today, and in fact for the past decade since the value factor began to underperform, it may be the lack of re-leveraging dynamics for value stocks that has eliminated the excess returns that investors are still waiting for. The tables seem to have turned on value vs growth excess returns not because of temporary cyclical effects that need ever more complex and dynamic factor structures (…data-mining?) but rather as a result of structural changes related to the (in)ability of value firms to optimize or use their capital structure.
Investors should not be discouraged to explore factor structures other than general equity markets factors and may benefit from taking a differentiated approach. Kania Advisors specializes in real estate and real assets. Our listed multi-factor indices for global real estate securities are structured based on factors relevant to real estate markets and real estate securities markets rather than general equity market factors.
For information about our services, please contact info@kaniaadvisors.com
About Kania Advisors
Kania Advisors is an independent research and advisory firm focused exclusively on institutional real assets allocations and investment programmes. We provide advice and solutions to improve outcomes in real assets investment programmes. We conduct detailed industry research and custom studies typically focused on quantitative analysis and provide insights which form a critical part of a client's decision process.