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2019-11-14 11:23:15

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Most investors instinctively know that the market is highly cyclical because how else can you buy low and sell high, but even professional investors might have been shocked as the S&P 500 logged five consecutive weeks of gains as hopes for even a phase one trade deal with China began to solidify. Whether that optimism is justified is debatable, but coming as a shock to no one was the total breakdown of the defensive trade with obvious losers being utilities, REITs and gold miners. What is surprising is that investors are looking for beta not in the tech stocks that have dominated the last few years but in out-of-favor names like Kraft Heinz (KHC) and General Electric (GE), the fallen titan that had seen an 80% drop in its market cap in just three years!

Both stocks have outperformed the broader market since the rally began on October 7th with GE up a stunning 31%, but investors thinking of rushing into the cheap but getting better theme might want to take pause before rushing into value funds. Ignoring the fact that GE or KHC are relatively small parts of the largest value funds, the sector is anything but homogenous with a clear distinction between traditional style funds and those that follow a more pure , smart-beta approach. Knowing the difference between them can mean a big difference in your returns.

Is GE Really Back?

The focus of this article isn't solely on GE, but its trials and tribulations can help shed some light on this new enthusiasm investors have for deeply unloved stocks. GE might be remembered for its old slogan We bring good things to life but its investors certainly haven't gotten to enjoy any good things as its stock price has significantly underperformed the broader market for years. Feel free to choose your own villain in the company's downfall; GE Capital, poor management in general or Jack Welch in particular, but the outcome is always the same. A loss of investor confidence and underperformance rarely seen outside of bankruptcy with the stock delivering a 10-year annualized return of just over 1.8% through November 8th versus 13.43% for SPY.

That includes a stunning drop with GE's market cap going from just over $300 billion in late 2015 to a mere $56 billion by late 2018. That's the equivalent of destroying two current Netflix's (NASDAQ:NFLX) or 1 Boeing (NYSE:BA) with another $50 billion leftover. That forced GE to cut its dividend, begin shedding assets (and people) to improve cash flow which only hurt the share price even more. But fast forward to 2019 and GE in fact has steadily outperformed analysts' consensus estimates for quarterly earnings which has raised hopes that the company might see consistently positive free cash flow. Meanwhile, the extreme valuations and slowing growth of some of the market's biggest tech names have investors taking another look at GE and other industrial/consumer names, but it's a shame that most value funds don't have that much exposure to them!

Most Value Funds have Little to No GE Exposure:

The first-place investors would traditionally look for fallen titans would be value funds, one third of the Morningstar Style box where those under-appreciated names would wait for mean reversion to kick their price multiples, and values, back into high gear. But as we mentioned before, there's a clear difference between value the style and value the factor. And where better to start our analysis than with a chart showing how some funds in both spaces fared over the last month?

As you can see, value the factor has significantly outperformed value the style over the last month, even among funds replicating the same index:

Invesco's S&P 500 Enhanced Value ETF (SPVU) has significantly outperformed the iShares S&P 500 Value ETF (IVE) over the last month, despite relying on the same investment index and index provider, Standard & Poor's! And even managed to do it with a slightly lower fee to boot! Surely, it's all that GE exposure right?

Wrong, because GE is a very small part in some of the biggest value funds:

As you can see, most of the big large-cap value funds have relatively small allocations to GE which is hardly surprising given that most are also market-cap weighed, which means the biggest stocks typically have the biggest allocations. Thanks to that rapid loss in market cap, GE has become a progressively smaller part of these funds, meaning its overall impact on their returns is relatively minor.

But in fact, most of the year's top performers are also missing GE exposure, partly a function of the fact that many value factor funds include an implicit quality screen to keep deep value stocks, those with falling or negative earnings, out of their portfolios. This can take the form of either needing a positive P/E ratio or consistent earnings growth, something that would've kept GE far from the allocation, although that's not the only thing to consider. What else explains the different performance among the top funds? To understand that, you have to understand what exposure you're actually getting when you use a value factor fund.

Value with a Capital V

Value investing may have begun with Benjamin Graham, but it was also one of the first factors being included in the famous Fama & French three-factor model. And while there's a lot of overlap between value (style) and Value (factor), there can be substantially different performance between the funds following each system, which is why you need to understand them before you buy.

Maybe the best way to understand the differences between them is to consider those two funds that have the same reference index (the S&P 500) and rely on benchmarks prepared by the same firm, Standard & Poor's. The first fund is the iShares S&P 500 Value ETF, which provides large-cap value style exposure using only S&P 500 components, while the second fund is the Invesco S&P 500® Enhanced Value ETF, which arguably does the same thing but in much more concentrated exposure. How do they work?

IVE begins by following the same basic process that almost every index sponsor follows, categorizing your investment universe based on two sets of metrics looking at growth and value. For example, S&P generates its growth scores using the three-year growth trend in sales and earnings per share among other factors along with trailing 12-month price momentum. It then determines value scores built around using common price multiples like P/E, P/B, or P/S. Every stock has both a value and a growth score, so to rank its universe, it divides the growth score by the value and then separates them into style baskets based on percentile rankings. Stocks in the top third are growth, the bottom third are value and the rest are blends. Seems simple enough except two sponsors might have very different takes on the process.

In the S&P 500, no one would doubt Facebook (NASDAQ:FB) is still a growth stock while Exxon Mobil (NYSE:XOM) clearly belongs in value, but where does Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) belong? Vanguard has it in its Vanguard Value Fund (VTV), but you'll find it also in the iShares S&P 500 Growth ETF (IVW) not its value equivalent IVE. Remember that different sponsors can have different methodologies, so while a stock might be in either a growth or value fund at Vanguard doesn't mean it's the case for S&P! That's how another weak performer like Johnson & Johnson (NYSE:JNJ) is in IVW, helping drag it into the lower half of large growth funds this year!

With over 386 holdings, IVE clearly includes a large number of blend stocks whose value score is still at least somewhat greater than its growth, but clearly dilutes the factor exposure that some investors crave which is where SPVU enters the picture. SPVU's benchmark also comes from S&P and follows the same construction process up until a certain point. Instead of having almost every stock with any value exposure, SPVU's index only uses the 100 highest scoring stocks in the style basket, which it then weights by both market cap and the value score. That lets the most value-oriented names take charge of the returns, but what kind of portfolio does that give you?

To start, it's one without GE exposure, although that's hardly the only big difference. SPVU does have 98 holdings, almost all of which are also found in IVE (we assume the few that are excluded from larger IVE because of liquidity) but there are some major names missing from SPVU Including IVE's two largest holdings, Apple (OTC:APPL) and JPMorgan (JPM) that make up over 12% of the fund! Add up all the other IVE holdings missing from SPVU and just 23.8% of IVE's portfolio is replicated in SPVU and what cross-holdings they have in common have such different weights that you really have two entirely different strategies.

For example, SPVU and IVE both have some common names like AT&T (T), Bank of America (BAC) and Citigroup (C), but in each case, their SPVU weights are anywhere from 260 to 320 bps higher than in IVE. That builds a portfolio with nearly 2x the financial exposure, almost 40%, of IVE along with more industrial and energy exposure along with substantially lower technology exposure at just 5% to IVE's 17%. How has the strategy performed?

Well, that depends on whether value the factor is what investors want, with SPVU typically outperforming when investors begin casting about for a pure value strategy with the last month a perfect example of that. As you can see in the table below, SPVU is slightly trailing IVE YTD although strongly outperforming it in the last month as investors begin to look for opportunities in value stocks. And while SPVU has been the stronger performer over the last three years, you have to watch what's going on with the broader market, specifically growth funds, to know the whole story. IVE's growth counterpart, IVW, was almost flat in 2018 while IVE was down close to 9.2% and SPVU was down 9.5%. That may seem like a minor difference, but remember that IVE and SPVU draw from the same investment universe, which limits the possible performance differential. One of the largest dedicated value factor funds, the iShares Edge MSCI USA Value Factor ETF (VLUE) was down over 11%.

Spotting the Value

There are almost as many funds as reasons to add value exposure to your portfolio, but investors need to know what kind of value they're getting. So how do you spot a smart beta fund from a style one? You could start by looking at the names where smart beta funds will use terms like enhanced or pure or even tilt where style funds will use a combination of the index name and value or in the case of Vanguard, use only value.

Those looking to do a deeper dive should use other criteria like looking at the degree of concentration (fewer holdings probably means more value) along with sector exposure (industrials versus technology). But which should you pick? That depends on the current mood of the market, but most importantly, how growth funds are doing in general. The worst the situation for growth, the better the possible outcomes for a pure value fund!

Thank you for reading!

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