Traditionally value managers used the book-to-price ratio (B/P) as their standard value metric. The B/P ratio served value managers well back when economies were largely industrial. However, as the developed world shifts to a service- and knowledge-based economy—thanks in part to the catalysing effect of COVID-19—the B/P ratio has become a less meaningful metric and used on its own fails to capture some important information.
As more and more companies invest in the creation of intangibles such as R&D, patents, and other intellectual property, the book value of these companies can be greatly understated by an investor relying solely on the B/P ratio. Because the book value of a company does not reflect the value of intangible assets, managers tend to use price/earnings (P/E) and similar ratios in conjunction with traditional value metrics like the B/P ratio in order to get a better understanding of a company’s fundamentals and prospects.
A recent study in the Financial Analysts Journal showed that, due to this trend of using a broader set of metrics, many value managers now have portfolios filled with stocks that would previously have been categorised as growth stocks. This raises interesting questions about how we define value and growth, and the extent to which the lines can become blurred.
There was a sigh of relief for many investors incorporating value strategies in their portfolios when in Q4 2020 we saw a long-awaited rally in value stocks. Unfortunately, for many ‘value’ managers, the rally did not seem to extend to their own portfolios. On closer inspection, it appears that value with a quality bias generally did not join in the rally, but that it was predominately cyclicals that performed strongly as the market gained more confidence in the COVID-19 vaccine rollout.
What does this mean for value managers?
Firstly, it means that those traditional value strategies that stuck to their knitting (or as some may now argue, stuck to a very narrow definition of value) and built portfolios comprised of quality companies trading at a discount to their perceived value underperformed the market. Secondly, it means that managers who were less focused on quality—or were less narrow in their definition of value—may have been rewarded.
So why would quality value not rally with the rest of value? Quality is typically referred to as a factor using a collection of metrics indicating robust financial health within a company. While there is no standard definition of quality, according to a recent article, it is typically a combination of broad categories including profitability, earnings stability, capital structure, growth, and other such metrics.
Why did these types of quality companies not participate in the rally? When will the market finally recognise their value? These are questions baffling today’s investors, and it may be some time before we ever find satisfactory answers. For now, we can only be aware of the challenge and respond to it by maintaining exposure across a broad selection of styles and strategies, and by understanding the nuances of each investment and how it may or may not react in certain market conditions.
Ultimately what matters to investors is not the relative returns over the past decade or century, but the relative returns over an investor’s time horizon. On that basis, predicting the winning style is impossible. But making sure we are diversified across a range of styles is not only possible but prudent.
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