In early March, 130 of our clients, consultants, advisors, academics, and Causeway professionals gathered in Laguna Beach, California for our second biennial conference, Causeway Convergence: Dynamic Value. Against the backdrop of the magnificent Pacific Ocean, the Causeway research team analyzed the shifting tides of equity markets. Conference guests exchanged ideas on issues impacting their professions and their constituents. We looked ahead, as guest speakers Barclays’ CEO Jes Staley, technology entrepreneur Peter Diamandis, and economist Austan Goolsbee articulated their visions for how current policies and innovation would interact to shape the coming years.
The need for innovation—even within the long tradition of value investing—inspired the conference theme: Dynamic Value. The concept underpinning value investing is simple: buy stocks the market has priced too low…and wait. But this general description masks the diverse environments that produce undervaluation, and what causes the gap between market and intrinsic values to close. The better we as investors understand—and can exploit—value’s complexities, the greater returns we can generate for our clients.
Last year’s equity market performance highlighted the dynamic nature of value investing. Despite a substantial June Brexit setback, 2016 ushered in a sharp rebound in the performance of value style investing. The value indices, with large concentrations in financial stocks, experienced the largest recovery over the calendar year, after having suffered significantly in prior years. Value recoveries have typically occurred quickly. “Timing” the value factor sounds good in theory, but success remains illusory in practice. What can active management deliver beyond the already attractive alpha (return in excess of the benchmark) stream from the value indices? How does Causeway define value, and what type of value do we offer our clients? To address the value cycle, Jamie Doyle, portfolio manager, and Ryan Myers, senior quantitative research analyst, scrutinized value’s behavior and presented their findings at our conference in The Hitchhiker’s Guide to the Value Cycle. In this newsletter, they share highlights of their analysis.
JD: For fans of Douglas Adams’ classic science fiction adventure, The Hitchhiker’s Guide to the Galaxy, I’ll start with the answer: “42”--then, we must find the question. It is difficult to dispute that value has outperformed growth over the past 25 years, measured as value indices relative to standard indices, or returns to value factors compared to returns to other systematic factors. However, there is still some ambiguity in value’s definition.
RM: We often get asked about value indices and their effectiveness. The formulaic definition of value by benchmarks has resulted in pronounced sector biases. For example, over 30% of the MSCI EAFE Value Index market capitalization is comprised of non-real estate financial stocks. Value indices have shorter investment horizons, as their metrics use current or next-twelve-months data. Furthermore, these indices assume that half of the investable universe consists of value stocks, an overly rigid construct made even more artificial by static country weights.
JD: These “risky” indices make investing in passive value somewhat problematic. We seek to construct value portfolios for clients that have less volatility and beta (sensitivity to the benchmark index) than the value indices, which have exhibited sector skew.
JD: Our clients can get exposure to value factors cheaply, via smart beta strategies. However, they want more than just a general overweight to the value risk factor – and we believe we have delivered more since the inceptions of our value strategies. Causeway’s bottom-up stock selection process is designed to result in dynamic style exposures to factors such as value, momentum, cyclicality, and even growth.
RM: Diversification of factor exposure is really important. Look, for example, at how crowded the “Quality/Defensive” segment of markets became by late 2015, while value attracted few buyers. The more crowded and concentrated the factor exposure, the greater the rebound when mean reversion begins. Those rebounds tend to occur very quickly, making it difficult to time the recovery. As long and painful as value drawdowns can be, in many instances the recovery has rapidly reached new highs, rewarding the patient investor.
JD: In Causeway’s Global and International value equity strategies, my colleagues and I expend significant time and effort evaluating all aspects of the investment case. We give ourselves wide latitude by geography and industry. Our process typically brings other active risk exposures to client portfolios. We attempt to smooth the value cycle by using our own quantitative tools such as earnings momentum, screening for financial strength, and short position monitoring. With this approach, stock selection, rather than style exposure, has been the primary driver of investment returns.
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