After a long run in the doldrums, value stocks are interesting again. In the following Q&A, Research Affiliates’ Chairman Robert Arnott and CIO Christopher Brightman, along with PIMCO executive vice president and product manager Andrew Pyne, discuss the case for value stocks, which have broadly underperformed growth, and outline how PIMCO RAE Fundamental strategies can play key roles in investors’ portfolios.
Q: Why and how did you develop these strategies? What are the core principles underlying them?
Robert Arnott: The beauty of the PIMCO RAE Fundamental portfolios is that they are all, at their core, contrarian rebalancing strategies designed to outperform the market by breaking the link between price and portfolio weighting. By systematically contratrading against the market’s most extreme bets, selling the mostbeloved and extravagantly priced stocks, and then buying the most newly-loathed or feared companies at extreme discounts, we win in the long run. Some stocks deserve their high prices, some don’t. Some of the lowest-priced stocks are value traps, heading to zero, while some are true bargains. In our view, these strategies are an elegant way to capture this structural source of return and diversification to deliver potentially meaningful excess return with sensible risk.
We know that unless markets are perfectly efficient, prices stray from the unknowable fair value. Still, market participants constantly seek fair value. This leads to long-horizon mean reversion in prices. We position ourselves to take advantage of mean reversion,1 a powerful force that works on a long-term, but not a short-term, basis. Although future performance is not possible to predict, if we win in six out of 10 years, in three out of four rolling three-year spans, and in eight out of 10 rolling five-year spans, we should be better than all but a handful of the very best active strategies and managers.2 Any client who cannot tolerate underperformance over any three- or five-year span should likely invest in conventional cap-weighted index strategies. For those with patience, we offer a compelling process.
The PIMCO RAE Fundamental strategies have continuously evolved based on our research findings. At the core of each of these strategies is a time-tested philosophy that seeks to deliver a reliable source of excess returns. Our strategies begin with a portfolio that selects and weights companies by fundamental measures of size – sales, cash flow, dividends and book value – then annually rebalances them. Anchoring to these fundamental weights allows our strategies to retain favorable implementation benefits, including but not limited to low turnover, low cost (due to low turnover), and broad representation of the macroeconomy (weighted according to a company’s economic footprint, instead of its popularity, as cap-weighting does).
These strategies then build upon our original work, by including new insights on smart beta,3 implementation and risk diversification. For example, being mindful of momentum protects against aggressively rebalancing into (or out of) rapidly depreciating (or appreciating) positions. Additionally, the incorporation of financial health is designed to reduce exposure to companies that are distressed, have poor growth prospects or exhibit aggressive accounting techniques. Finally, our risk-diversifying process seeks to optimize long-term, risk-adjusted returns by redistributing active “bets.”
The RAE Fundamental suite of equity strategies is exclusively available through PIMCO. For more than a decade, we’ve appreciated the interaction withPIMCO’s remarkably deep team of talented professionals. We believe that combining our product design with PIMCO’s outstanding client service and portfoliomanagement capabilities will enable us to better serve our investors seeking innovative and time-tested investment strategies.
Despite seeing some glimmers of a reprieve in 2015, value has uncharacteristically been savaged across the board in recent years, as my colleague Chris Brightman will touch on. Will this unusual environment persist in the years ahead? Perhaps, but I wouldn’t bet on it! Indeed, the turn may already have happened. My decades as a contrarian, value-oriented investor have taught me, again and again, that market participants are driven by a quest for fair value and that contratrading has the potential to be generously rewarded, though not in every year. Investors chasing fads and bubbles will test the patience of some value investors. For those of us with the courage to “average in” to a more aggressive value stance, whenever the market is on a growth binge, we should have maximum value exposure when value turns, and potentially earn back each shortfall with room to spare. While history does not always foretell the future, I’ve seen this happen again and again in the past 39 years.
Value has underperformed severely since 2007. Looking forward, with value trading near historical lows of relative valuation, I am highly confident that mean reversion will come. We are convinced of the long-term merit of our strategies as a source of risk-managed additional return and, for most investors who do not already have a deep-value bias, added diversification to an overall portfolio.
Q: Does value investing still make sense?
Christopher Brightman: Yes! The adage “buy low and sell high” exists for a reason. While value investing has been challenged recently, it is and always has been a discipline that requires conviction and patience. We remain confident that the practice of buying quality assets at discount prices will eventually be rewarded by growth in wealth.
Benjamin Graham and David Dodd first popularized value investing in 1934 in their seminal work, “Security Analysis”. Ever since, many disciples, famouslyincluding Warren Buffett, have profited from the value investing style. Academic research documenting the potential profits available to value investing can be traced back almost 40 years. Sanjoy Basu in 1977 rigorously documented the value premium. Eugene Fama and Kenneth French in 1992 built the value factor (high minus low), propelling value investing into the core curriculum of every business school and the value factor into every investment analytics system.
While value investing works over the long run, investing in underpriced companies certainly does not pay off every week, month or year. We have recently experienced a prolonged period of underperformance. The performance of value has been so poor recently that the 10-year value premium in the U.S. has turned sharply negative (see Figure 1). The Russell 1000 Value has lagged the Russell 1000 Growth by more than 2.5% annualized for the 10 years ending 31 March 2016 (5.7% vs 8.3%). The good news for value investors is that prolonged underperformance means that cheap stocks have become even cheaper. In our opinion, value stocks are on sale.
To profit from the value investing discipline, investors must understand that the excess return potential from value is cyclical and mean reverting. Periods of underperformance have historically been followed by periods of outperformance. Importantly, our research indicates the magnitudes are linked. Outperformance of value is generally strongest following periods of the most substantial underperformance. Value underperformed spectacularly after the savings and loans crisis and during the tech bubble and financial crisis.
Of course, these periods of substantial underperformance try the patience of value investors. To potentially profit from value investing, however, requires the discipline to avoid capitulation during these inevitable periods. Giving in to the urge to chase past performance destroys wealth. Value funds as a group have meaningfully outperformed the market, as measured by their time-weighted returns. Yet, the average investor in these value funds underperformed the market, as measured by their dollar-weighted returns.4 Their performance chasing timing was that bad!5
In the PIMCO RAE Fundamental suite of equity strategies, we seek to generate excess returns by taking advantage of this behavioral tendency to pile in to the most popular companies, sectors, countries, etc. Rebalancing out of the most loved companies and into those shunned leads to a value tilt, which is dynamic in nature. By systematically rebalancing to non-price measures of size, we will have the greatest overweight to value companies precisely when these companies are cheapest relative to the broader market.
We do not buy cheap companies indiscriminately. Incorporation of financial health into company selection and weighting helps us avoid “value traps.” Welook to reduce positions in companies headed for distress by avoiding over-levered firms. We may reduce positions in companies that intend to report large write-offs by avoiding those that employ aggressive accounting. We may trim positions in companies with weak earnings growth prospects by favoring firms with high returns on capital, a “moat.” Finally, by seeking to avoid companies whose prices have been declining quickly, we cut exposure to the proverbial “falling knives.”
Value investing is not dead. There is a silver lining to the recent underperformance of value companies. They are now positioned for strong future excess returns. Indeed, while we are loathe to definitively call a bottom until well after it has occurred, the rebound in cheap companies in the first few months of 2016 suggests that the turn in performance of value investing may have already begun (see Figure 2).
Q: How do clients use PIMCO RAE Fundamental strategies?
Andrew Pyne:When we talk to PIMCO clients about their equity allocations, we see many investors struggling with the same challenges. After a very strong run in equity market performance since the bottom in 2009, investors are navigating what we expect to be a much lower-return environment ahead. In addition, after yearsof unusually strong outperformance of growth stocks and more recently a market characterized by a lack of breadth, investors are seeking to benefit from a change in market leadership. Both Rob and Chris referred to mean reversion, which is likely to occur. Within this context, we have found that PIMCO RAE Fundamental strategies can play several different roles in client portfolios.
Enhancing the core. Most investors make strategic allocations to core segments of the equity market, such as domestic equities, international equities and emerging markets. Or they may aim to capture exposure to all of these areas in a global strategy. Over the past several years of high returns, investors have increasinglyutilized passive strategies for these core allocations. However, in the environment ahead, these passive allocations may not deliver the returns investors require to meet their goals. Beta alone may no longer be enough. PIMCO RAE Fundamental strategies may serve as a solution in the core, providing many of the benefits of passive, such as broad diversification, economic representation and low turnover, while adding the potential for needed excess returns.
Benefitting from the return of the value premium. Chris outlined the growth/value dynamic of the past several years and how value stocks may be poised for attractive future returns given their significant valuation discounts. Indeed, PIMCO believes that there are potential catalysts for a change in style leadership, including continued economic recovery, rising rates and the fact that, yes, valuations matter! PIMCO RAE Fundamental strategies, in our opinion, can be a reliable way to benefit from potentialvalue outperformance given their dynamic exposure to value stocks. The rules-based aspect of the process and the active insights that are applied result in portfolios that “load up” on value stocks when they are cheap but also reduce that deep value bias when value stocks become more expensive. Given the recent underperformance of value and RAE’s systematic buying of these cheap stocks, all RAE strategies have meaningful valuation discounts relative to market-cap-weighted indexes.
Replacing value managers. While value has been out of favor, what has compounded this headwind for many investors is that their active value manager has further underperformed the value benchmark. In evaluating their manager lineup, many clients recognize that the PIMCO RAE Fundamental strategies may be a better form of value investing. RAE is based on fundamental weighting, which results in a completely emotionless, disciplined rebalancing strategy that seeks to consistently buy low and sell high. The strategies also benefit from the ongoing research and insights of Research Affiliates, incorporating measures of a company’s financial health and recent momentum into portfolio weights, as well as redistributing active weights to further enhance risk-adjusted returns.
Differentiating among smart beta and factor investment strategies. The rise of “smart beta” strategies has introduced investors to a third equity option beyond traditional active and passive approaches. While this creates opportunity, the proliferation of a disparate array of factor- and rules-based products also creates confusion and risk. As clients try to make sense of the space, PIMCO RAE Fundamental strategies stand out in three important ways. First, as active strategies built onfundamentally weighted smart beta, RAE offers a clear and intuitive investment philosophy and process as opposed to competing approaches that may be more of a “black box.” Second, when many new products are introduced, they are supported solely by back-tested results; by contrast, the PIMCO RAE Fundamentalstrategies have live track records of more than 10 years! And third, while breaking the link between price and portfolio weight can result in outperformance of market-cap-weighted indexes, implementation is often the key differentiator. We have thoughtfully created PIMCO RAE strategies in an effort to keep trading costs low, with the intent to allow for greater capacity and potential for higher returns.
PIMCO and Research Affiliates continue to collaborate on offering equity solutions to meet client needs. PIMCO offers a broad array of strategies that seeks to deliver compelling excess returns, including RAE Fundamental, which is designed for strategic equity allocations with betas of roughly 1.0; RAE Low Volatility, which are more concentrated strategies constructed to provide an attractive risk-adjusted return profile with an expected beta of about 0.7; and RAE long/short and market neutral strategies made for return potential and further equity risk reduction.
All of these strategies can play a role in helping investors navigate the more challenging environment ahead.
1 A core tenet of our investment beliefs is that the largest and most persistent active investment opportunity is long-horizon mean reversion. Please seeResearch Affiliates Fundamentals “Our Investment Beliefs” (October 2014).
2 I would note that, while the best active managers can be remarkable, it’s very hard to identify them in advance. By the time that their competence isself-evident, they’re often rich and complacent. So, how much longer will they be winners? A disciplined process – if sufficiently well-crafted – doesn’tshare this vulnerability.
3Smart beta refers to a benchmark designed to deliver a better risk and return trade-off than conventional market-cap-weighted indexes.
4Hsu, Jason C., Myers, Brett W. and Whitby, Ryan J., Timing Poorly: A Guide to Generating Poor Returns While Investing in Successful Strategies (1 May2015).
5Unfortunately, this mistake is not unique to value investors as we show in our Fundamentals “Woe Betide the Value Investor” (February 2015).