{"id":38594,"date":"2014-12-03T08:06:00","date_gmt":"2014-12-03T07:06:00","guid":{"rendered":"http:\/\/beta.next-finance.net\/opinion\/brave-value-investing\/"},"modified":"2019-12-30T23:13:59","modified_gmt":"2019-12-30T22:13:59","slug":"brave-value-investing","status":"publish","type":"post","link":"http:\/\/beta.next-finance.net\/en\/opinion\/brave-value-investing\/","title":{"rendered":"Brave Value Investing"},"content":{"rendered":"

According to Soci\u00e9t\u00e9 G\u00e9n\u00e9rale\u2019s cross asset
\nresearch team, there are two types of value
\ninvestor: patient value investors, who seek to
\nbenefit from compounding above-average
\ndividend yields offered by quality companies;
\nand brave value investors, who seek to gain from
\na share price recovery in companies currently
\ndiscounted by the market. In this expert opinion,
\nandrew lapthorne, head of quantitative
\nequity research at Soci\u00e9t\u00e9 G\u00e9n\u00e9rale, and
\nFran\u00e7ois millet, lyxor\u2019s product line
\nmanager for etFs and Indexing, explain the
\nindex concept.<\/strong> <\/em><\/p>\n

Building a portfolio
\nmixing such types of
\nrisk factor strategies is
\nbecoming increasingly
\npopular as an alternative
\nto diversifying in
\nthe traditional way,
\nby asset class.<\/quote><\/p>\n

Why should an investor consider using a value strategy?<\/strong><\/p>\n

Andrew Lapthorne:<\/strong> As a strategy, value investing has
\nbeen around for decades. It was first popularised by Ben
\nGraham and David Dodd in the 1930s and has since been
\nadopted by many successful money managers, most
\nnotably Warren Buffett.<\/p>\n

Many studies have shown that a strategy of buying and
\nholding undervalued stocks has generated superior longterm
\nreturns to other strategies, for example buying growth
\nstocks or owning the market as a whole.<\/p>\n

There are different approaches to identifying value\u2014for
\nexample, selecting the stocks with the lowest ratio of
\nmarket price to book value, or stocks with high dividends
\nor low price\/earnings ratios. But the central theme of these
\nstrategies is the same: an investor buys shares that are
\nrelatively out of favour but which end up outperforming more
\nglamorous stocks over time.<\/p>\n

What are the sources of return of value strategies?<\/strong><\/p>\n

A. L:<\/strong> There\u2019s a lively debate about why value stocks pay a
\nreturn premium over time. One explanation is that investors
\nare receiving an extra return for owning companies with
\nlower valuations (and therefore a higher risk of financial
\ndistress or default).<\/p>\n

Another is that the value premium is caused by the
\nirrationality of investors seeking to match or outperform
\ncapitalisation-weighted market benchmarks. By chasing
\nhigher-momentum growth stocks, these investors leave
\nother stocks undervalued, offering a return premium.
\nIn our view both explanations have some merit. Both are
\nconsistent with the idea that investors are rewarded for
\nacquiring and owning unpopular stocks.<\/p>\n

How do value strategies compare with other \u201csmart beta\u201d or \u201cfactor\u201d approaches?<\/strong><\/p>\n

A. L:<\/strong> Value is one of a number of \u201csmart beta\u201d or \u201cfactor\u201d
\nstrategies. Factor strategies in the equity markets include
\nvalue, momentum, small-cap and low-volatility. In the fixed
\nincome, foreign exchange and commodities markets, factor
\nstrategies include momentum and carry.<\/p>\n

Building a portfolio using factors is becoming increasingly popular as an alternative to diversifying in the traditional way, by asset class.<\/p>\n

SG\u2019s research team has identified that the historical correlations across factor risk premia are lower than correlations across asset classes, and that cross-factor correlations are also more consistent and more robust to
\nshifts in market \u201cregime\u201d.<\/p>\n

So buying and holding exposures to factors may be a more dependable way of earning risk premia than, for example, trying to overweight equities versus bonds.<\/p>\n

What is the SG Value Beta index? How does
\nit differ from the SG Quality Income index?
\nAre they bo th value indices?<\/strong><\/p>\n

A. L:<\/strong> We think that there are essentially two different types
\nof equity value strategy.<\/p>\n

The first offers a return premium from investing in higherquality,
\nless cyclical, lower-leverage companies with above
\naverage yields. Such stocks are likely to underperform in a
\nrising market but offer better protection in a downturn.
\nThis type of strategy\u2014which we call \u201cpatient value\u201d\u2014
\nis represented by the SG Quality Income index and the
\nassociated range of Lyxor ETFs. It aims to deliver long-term
\nreturns from the compounding of an above-average yield,
\ntogether with a reduced capital drawdown risk.<\/p>\n

the second type of value strategy\u2014which we call \u201cbrave
\nvalue\u201d\u2014focuses on buying under valued stocks during a
\nperiod of relatively higher risk. An example would be buying
\nBP after the 2010 Deepwater horizon oil spill, before
\nknowing when the oil spill would be capped. the risk of an
\ninitial capital loss is higher, but the attraction is that you are
\nbuying the stock at a heavy discount to fair value.
\nThis \u201cbrave value\u201d approach is represented by our new SG
\nValue Beta index.<\/p>\n

What have been the long – term returns
\nof the two strategies and how much
\nof the returns have come from capital
\nappreciation and income?<\/strong><\/p>\n

Fran\u00e7ois Millet:<\/strong> Based upon a back-test, both the SG Quality Income and the SG value Beta indices have provided positive long-term returns relative to a Market Cap Index.<\/p>\n

\"comparing_quality_income_value_and_combined.jpg\"<\/p>\n

over a twenty-year period from 1994, the sg Quality Income
\nindex and the sg value Beta index gave average
\nannual returns of 12.3% and 15.4%, respectively,
\ncompared to an average return of 8% from the Market Cap
\nIndex.<\/p>\n

There was a difference in the composition of returns,
\nthough. More than half of the average annual return
\nfrom the SG Quality Income index came from the
\ncompounding of dividends. But over 70% of the average
\nannual return of the SG Value Beta index resulted from
\ncapital appreciation.<\/p>\n

\"decomposition_of_index_returns_into_capital_and_dividend_components.jpg\"<\/p>\n

Patient value investing is mainly about yield, whereas
\nbrave value investing is mainly about potential share price
\nincreases.<\/p>\n

What volatility and drawdow n risks are associated with the value beta approach?<\/strong><\/p>\n

F.M:<\/strong> As you might expect from its focus on under valued
\nstocks, the sg value Beta index has had higher volatility
\nhistorically than the market, with a larger maximum
\ndrawdown.<\/p>\n

However, the return-to-risk ratio of the sg value Beta
\nindex was higher than that of the market index. We
\ncharacterise the value Beta approach as offering potentially
\noutsized returns with volatility.<\/p>\n

What is the methodology of the SG Value Beta index?<\/strong><\/p>\n

A. L:<\/strong> We rank stocks according to their relative valuations
\nwithin global industry sectors, using the equal-weighted
\nscores of five traditional value factors, all of which have been associated with positive long-term excess returns in academic literature: book value to price, earnings to price, forward earnings to price, EBITDA to enterprise value and
\nfree cash flow to price.<\/p>\n

We select the cheapest 200 companies worldwide,
\nbased upon this value scoring system, and we equalweight
\nthem in the index. Only companies with a freefloat
\nmarket capitalisation exceeding US$1 billion and
\nsix-monthly average daily trading volume of US$3 million
\nor more qualify for the starting universe. The index is
\nrebalanced quarterly.<\/p>\n

How does the SG Value Beta index compare with value indices from other
\nindex providers?<\/strong><\/p>\n

A. L:<\/strong> Over the years, value indices have become relatively
\nmore sophisticated in their methodology. For example,
\nuntil 2003 MSCI sorted stocks into \u201cvalue\u201d and \u201cgrowth\u201d
\ncategories solely on the basis of companies\u2019 price-to-book
\nratios. This approach was questioned when in 2002 the
\nMSCI Value index suddenly became more expensive in P\/E
\nterms than the MSCI Growth index.<\/p>\n

MSCI modified this first-generation value index in 2003,
\nadding earnings and dividend yield to their value scoring
\nsystem. We would regard Russell\u2019s value index methodology,
\nwhich focuses on book value-to-price and sales-to-price, as
\nanother example of a second-generation value index.<\/p>\n

SG\u2019s Quality Income and Value Beta indices are thirdgeneration
\nvalue indices, using a variety of share pricedependent
\nand fundamental value metrics to determine
\ncompany rankings.<\/quote><\/p>\n

Our objective in designing the indices was to have a
\nconsistent and simple methodology in a realistic and
\nimplementable form.<\/p>\n

In what market regimes have the SG
\nValue Beta and SG Quality Income indices
\nperformed relatively better\/worse?<\/strong><\/p>\n

F. M:<\/strong> In the chart below we show the relative performance
\nof the SG Value Beta index and the SG Quality Income index
\nduring different market conditions: under strongly rising
\nmarkets, range-bound markets and strongly falling markets,
\nas well as overall during up months and down months, over
\na twenty-year period.<\/p>\n

The SG Value Beta index has tended to outperform during
\nperiods of rising markets, especially strongly rising markets.
\nIt tends to underperform the market index slightly during
\ndownturns.<\/p>\n

The SG Quality Income index tends to lag the overall market
\nindex in bull markets but to outperform strongly in bear
\nmarkets.<\/p>\n

\"the_performance_of_each_index_under_different_market_conditions_1994-2014_.jpg\"<\/p>\n

How should investors combine the SG Value Beta and SG Quality Income indices in a portfolio?<\/strong><\/p>\n

F. M:<\/strong> The fact that the two indices perform so differently
\nduring different market regimes suggests that an investor
\ncan obtain significant diversification benefits by combining
\nthem in an equity portfolio.<\/p>\n

One way of doing this might be a simple 50:50 allocation
\nbetween the two index strategies.
\nAlternatively, an investor
\ncould seek to invest in either of the two indices using a
\nregime-switching model, for example using statistical
\nforecasting to determine whether to allocate to the more
\nbullish SGVB index or the more defensive SGQI index.<\/quote><\/p>\n

We have shown the relative performance of the SG Value
\nBeta and SG Quality Income indices, together with an equalweighted
\nportfolio investing in the two indices and a regimeswitching
\nmodel in the chart below. We think the two index
\nstrategies are highly complementary.<\/p>\n

\"using_regime_switching_models_can_help_improve_historical_returns_versus_equal-weight.jpg\"<\/p>\n

What country and sector exposures are prominent in the SG Value Beta index?<\/strong><\/p>\n

F. M:<\/strong> Currently, the SG Value Beta index has a substantial
\noverweight position in Japanese stocks and a relative
\nunderweight position in the US equity market by comparison
\nwith the MSCI World Value index.<\/p>\n

From a sector perspective, the SG Value index currently
\noverweights financials and underweights defensive sectors
\nsuch as healthcare and consumer staples, again by
\ncomparison with the MSCI World Value index.<\/p>\n

What other value strategies does Lyxor offer in ETF format?<\/strong><\/p>\n

F.M:<\/strong> Lyxor offers ETFs on traditional value indices, such
\nas the Lyxor ETF MSCI Value and the Lyxor ETF Russell
\n1000 Value, as well as ETFs on third-generation value
\nindices, the Lyxor ETF SG Quality Income and the Lyxor
\nETF SG Value Beta. The SG value Beta ETF must be
\nconsidered as an ETF with a high value factor and provides
\nideal tool in a factor allocation strategy.<\/p>\n

How much do these ETFS cost?<\/strong><\/p>\n

F.M:<\/strong> The Lyxor ETF MSCI Value, Lyxor ETF Russell 1000
\nValue and the Lyxor ETF SG Value Beta have an annual total
\nexpense ratio of 0.4%. The Lyxor ETF SG Quality Income
\nhas an annual total expense ratio of 0.45%.<\/p>\n

These annual fund charges are highly competitive with actively
\nmanaged value funds. And our analysis shows that very few
\nactive value managers have managed to beat the new SG
\nValue Beta index: only 6% of active funds within Morningstar\u2019s
\nGlobal Large-Cap Value Equity category have done better
\nthan the index over the last five years, for example.<\/p>\n

How wo uld you summarise the key features of the SG Value Beta index?<\/strong><\/p>\n

A. L:<\/strong> By acting as a complementary strategy to the SG
\nQuality Income index, which was launched in 2012, the SG
\nValue Beta index enables investors to capture the positive
\nrisk premium offered by distressed or problem stocks in a
\nsystematic, easy-to-understand and transparent way.