It's a lot harder than you might think to invest in a portfolio of pure value stocks.
I'm referring to stocks that trade for the lowest ratios of price to book value. Groundbreaking research by University of Chicago finance professor (and Nobel laureate) Eugene Fama and Dartmouth professor Ken French found that such stocks over the long term have significantly outperformed so-called growth stocks—those with the highest such ratios. They report that, from 1926 through 2018, the 20% of stocks at the value end of the spectrum have beaten the quintile at the growth end by 3.6 annualized percentage points.
To be sure, value stocks are coming off a decade in which they have significantly lagged behind growth, leading some to speculate that the so-called value effect no longer exists. Those in that camp, needless to say, aren't going to care that it may be difficult to invest in pure value stocks. But it is of concern if you are among those who believe that value stocks are poised to make a comeback.
According to a new study circulated a few weeks ago by the National Bureau of Economic Research, there are hardly any mutual funds or ETFs that consistently invest in the quintile of stocks with the greatest value. Titled "The Characteristics of Mutual Fund Portfolios: Where are the Value Funds?," the study was written by Martin Lettau, a finance professor at the University of California, Berkeley; Sydney Ludvigson, an economics professor at New York University; and Paulo Manoel, a Ph.D. candidate at UC Berkeley.
In fact, upon analyzing a comprehensive database of thousands of funds and ETFs between 1980 and 2016, they found just two that consistently have invested in this top quintile of value stocks. Even more incredibly: The average fund that self-describes its investment focus as "value" invests in stocks that are two quintiles away from the most value-oriented 20%—closer to the "growth" end of the spectrum, in fact. (See chart.)
Prof. Lettau emphasized in an interview that this surprising finding isn't a function of so-called style drift, which occasionally occurs after a sustained period in which value lags behind growth. At such times, of course, managers of value funds will be tempted to increasingly invest in growth stocks. But that isn't what is going on here, he stresses. On the contrary, the pattern has been persistent at least since the early 1980s.
Nor is the researchers' finding a function of managers shying away from using the price-to-book ratio as a proxy for value. They reached a nearly identical conclusion when using a number of alternative criteria of value, such as price-to-earnings ratios, price-to-cash-flow ratios and dividend yield.
The inability of both style drift and alternative definitions of value to explain the researchers' finding suggests that there may be a behavioral cause: Investors and advisers alike may find it distasteful to purchase stocks that most satisfy the criteria of value, no matter how strong value's historical performance over growth. Kent Daniel, a finance professor at Columbia University, says that he finds support for this hunch in his research showing that by the time a stock has a low price-to-book ratio, it often has suffered many years of poor price performance. And if a stock has lagged behind the market for many years, it may take a rare degree of courage to invest in it, he says.
You might wonder, therefore, why there are so few extreme value ETFs, since they typically are benchmarked to a particular index and manager discretion plays no role. But behavioral factors can influence an ETF's composition in other ways, such as in the choice of the index to which it is benchmarked in the first place. And sure enough, according to Prof. Lettau, almost all of the supposedly value-oriented ETFs are benchmarked to indexes that don't define value using the price-to-book ratio or similar metric.
How, then, can you gain exposure to extreme value stocks? One option is to invest in the very few funds that truly invest in such stocks, though this approach has its drawbacks. The fund that most consistently invests in value stocks, according to the researchers, is the Aegis Value Fund (AVFAX). But Aegis invests in microcap companies and therefore is inappropriate if you want to invest in midcap or large-cap companies in the extreme value quintile. The fund second to Aegis in terms of investing in extreme value is the JNL/Mellon Capital S&P Smid 60 Fund, which is offered only through a variable annuity.
Other than those two funds, the best you can do when investing in a mutual fund or ETF is to gain exposure to the top two quintiles of value. The largest funds available to individual investors that provide that exposure, according to the researchers, are the Franklin Balance Sheet Investment Fund (FRBSX), with a 0.92% expense ratio, and SA US Value Investor Fund (SABTX), with a 0.95% expense ratio.
An alternative is to construct a portfolio yourself of extreme value stocks. However, if you take this route, you need to build a big enough portfolio to be adequately diversified—at least 25 stocks, Prof. Lettau says. To give you an idea of the kind of stocks you will be investing in, here is a list of stocks in the S&P 1500 that have the lowest price-to-book ratios and that are currently recommended for purchase by at least one of the top-performing investment newsletters I monitor:
- Bank OZK (OZK)
- Brighthouse Financial (BHF)
- Capital One Financial (COF)
- Citigroup (C)
- Goldman Sachs (GS)
- Gulfport Energy (GPOR)
- Mallinckrodt (MNK)
- New York Community Bancorp (NYCB)
- PennyMac Mortgage Investment Trust (PMT)
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