Panning for gold

Along with saving countless lives, Covid vaccines have given a welcome boost to value investing, which focuses on stocks trading at cheap valuations relative to the broad market. Assuming a continuing economic recovery, the outlook for value remains favourable, ETF strategists say.

Among the most bullish is Antonio Picca, head of factor-based strategies with Pennsylvania-based Vanguard Group Inc., the parent company of Toronto-based Vanguard Investments Canada Inc.

“There’s a very good opportunity in value because of the fact that valuations remain at historical lows,” Picca said. “I remain bullish on value,” he added, even though the $204-million Vanguard Global Value Factor ETF has already been a big recent winner. It returned 47.3% in the 12 months ended Aug. 31.

The Toronto Stock Exchange-listed Vanguard ETF is a pure value play employing three factors: price to book, price to earnings and price to cash flow. “We really want to reflect what we believe is the consensus in the academic practitioner community around what value is,” Picca said.

The logic behind taking a global approach to value is that just as different regional equity markets will do well at different times, so too will value strategies. “The value premium can show up in different countries at different points in time,” said Picca, adding that the Vanguard global value ETF “allows you to have that extra element of diversification to the value premium.”

Over the past 10 years, the value premium has been mostly non-existent. Through July 31, the 8.8% annualized return of the MSCI World Value Index, as measured in U.S. dollars, has lagged well behind the MSCI World Index’s 11.7%. In all but three of the past 10 calendar years, the MSCI value index trailed the broad MSCI index of 23 developed countries.

The turnaround globally for value began late last year with Covid vaccine breakthroughs. This led to renewed optimism for an economic recovery, said Nirujan Kanagasingam, vice-president of ETF strategy with Toronto-based CI Investments Inc.

For the year ended Aug. 31, the CI Morningstar Canada Value Index ETF has returned 39.9%, the CI Morningstar US Value Index ETF (CAD hedged) is up 35.0%, and the CI Morningstar International Value Index ETF (CAD hedged) returned 33.4%. Though based primarily on below-market ratios of price to earnings, price to cash flow, price to book value and price to sales, the methodology means the CI ETFs aren’t pure value plays. The selection process also screens for upward earnings revisions, which is not a value metric.

Kanagasingam said the rebound in value stocks has been driven largely by cyclical sectors such as financial services and energy. “These sectors tend to be more sensitive to the economic cycle and do well when economic growth strengthens, which we saw when the economy started to reopen.”

The move by the G7 countries toward a minimum global tax rate of at least 15% also bodes well for value stocks, according to a June market commentary by Toronto-based Brompton Funds Ltd. That’s because value sectors “tend to have higher tax rates and fewer intangible assets compared to growth sectors.”

Chris Heakes, director and portfolio manager, ETFs, with Toronto-based BMO Asset Management Inc., drew parallels between now and 2009, the post-crash year when value last had an extended period of outperformance.

Heakes said the Covid-driven market crash of 2020 set the stage for a rotation into value stocks and away from growth. “One of the best markets for value tends to be that early recovery market.”

The BMO MSCI Canada Value Index ETF and the BMO MSCI USA Value Index ETF have both participated in that trend, returning 36.0% and 36.3%, respectively, in the 12 months ended in August. Their holdings are based on below-average price-earnings and price-to-book ratios, and relatively cheap enterprise value to operating cash flow.

Though concerns about the highly contagious Delta variant of Covid are leading to more restrictions, Heakes said value stocks remain attractive. “There’s potential for a little more life to that trade.”

Value’s robust rebound comes as growth stocks face less favourable market conditions. “Growth stocks have dominated value stocks over the last decade, primarily fuelled by low inflation and the low interest-rate environment that we’ve witnessed during this period,” Kanagasingam said. “This has been conducive for growth as many growth stocks are valued based on future potential earnings that have been discounted at significantly lower rates.”

The Covid pandemic only strengthened technology-heavy growth names, as lockdowns and the work-from-home trend led to increased demand for online shopping, virtual meetings and other technology products and services. But with the arrival of vaccines, the previously slumping economy experienced high GDP growth, surging inflation and upward pressure on interest rates.

In this type of market environment, said Kanagasingam, value has historically outperformed growth, “as companies and sectors that have experienced depressed earnings begin to see an acceleration in earnings growth.” As Picca observed: “We’ve gone through recovery, and value has done exactly what it was supposed to do.”

Now that value has had a market-beating run, where does it fit in investors’ portfolios? Though Heakes believes market conditions continue to be favourable for value, he advocates blending investing styles depending on the client’s personality and risk tolerance.

For a conservative investor, he said, combining value-style and low-volatility ETFs makes sense. “Value is more of a cyclical exposure and low vol is more of a defensive exposure,” he said. “Both factors can add benefits at various points in the market cycle. By pairing them up intelligently I think you can achieve better diversification.”

Over the long term, said Kanagasingam, value factors have been among the most studied and followed factors, and have historically generated strong returns. This makes value a compelling core addition to investor portfolios. “We generally recommend that investors approach their portfolio construction with a multi-factor lens in order to maintain diversification, with tactical opportunities to overweight or underweight certain factors depending on market conditions.”

Any investor should have an allocation to value, said Picca, who advises against trying to time market cycles. “Value is an important part of your portfolio,” he said. “Stick with it because the fundamental thesis behind value is just as relevant today, if not more relevant today than it has been.”