Key takeaways
- Value investing targets companies that are low in price when compared to their peers.
- Value investing is supported by economic theory and empirical data and can now be easily accessed through low-cost ETFs.
- Value strategies may use a combination of metrics such as Price to Book (P/B), Forward Price to Earnings (P/E), and Enterprise Value to Cash Flow from Operations (EV/CFO) to identify companies that look inexpensive relative to their fundamentals.
What is value investing?
Value investing is a strategy that targets stocks that are low in price relative to their fundamentals and peers. The concept of value investing has been around for decades. In fact, Columbia University professors Benjamin Graham and David Dodd noted in their 1934 book, Security Analysis, that investors should focus on purchasing securities at prices less than their “true” value.1
Imagine it’s the end of October and you still haven’t purchased your costume for Halloween. While we all like to think of ourselves as outstanding planners, many people find themselves scrambling to find a costume the week of Halloween. The trip to the store is nerve-wracking – with limited options and sky-high prices almost a guarantee. A few days later, starting November 1, those same costumes are typically offered on clearance. A savvy individual could purchase these discounted costumes, hold onto them until next October, and then make a tidy profit selling them at their original price points.
Like these savvy costume hunters, value investors are looking for companies “on sale.”
How do we define value investing?
BlackRock takes a multiple metric approach when proxying for value. Specifically, we look at a stock’s price relative to its book value and forward earnings, as well as its enterprise value relative to cash flows generated from operations. Utilizing a single metric to identify value securities may result in the addition of error through accounting noise. By incorporating multiple metrics focused on different areas of a company’s valuation, we can reduce the noise and feel more confident we may find a stock that is truly undervalued.
| Metric | Objective |
|---|---|
| Price-to-book | Identify undervalued stocks |
| Forward price-to-earnings | Find undervalued stocks with strong earnings on a forward-looking basis |
| Enterprise value to cash flow from operations | Evaluate stocks using a holistic company view (equity and debt) |
Source: BlackRock, MSCI
Let’s review each of these three metrics.
Price-to-Book (P/B) takes the price of a single share of stock divided by the company’s book value per share. This metric shows what the market is willing to pay for a single share of a company relative to its assets minus its liabilities. A higher price-to-book ratio relative to peers may indicate that a stock is expensive and should have a lower expected return. On the flipside, a lower relative price-to-book ratio may indicate that the stock is 'cheap' and should have a higher expected return. Much of the academic literature on value investing uses P/B as its proxy for value as the metric is consistently available and the denominator, book value, tends to be relatively stable over time.2
Forward-Price-to-Earnings (P/E) looks at the price per share of a stock compared to the 12-month forward earnings expectations of that stock. This metric seeks to evaluate the relative attractiveness of a company on a forward-looking basis. If two companies have the same stock price, but one has higher expected future earnings, the company with the lower forward P/E (higher denominator) may be considered inexpensive and should have the potential for higher future returns. One benefit of using a forward-looking metric in addition to P/B, is that it may help identify 'value traps'. A value trap is a stock that is priced cheap for a reason.
Enterprise Value to Cash Flow from Operations (EV/CFO) is an additional metric that provides a differentiated view of a company. Enterprise Value looks at the entire firm, not just equity, by adding a company’s total debt to its market value and then subtracting out its cash. Cash generated from the core business of a company (CFO) tends to be more sustainable than earnings generated from other business activities.
Depending on the metric used to evaluate a company’s value characteristics, an investor can have a significantly different experience. As shown in the chart below, there has been a wide dispersion in returns between different metrics.
Dispersion in returns between value metrics
Source: Bloomberg as of 09/30/2023. Net long-short return of equal weighted stocks in Quintile 1/ Quintile 5. Values are negative if bottom 20% (Q5) outperforms top 20% (Q1). Starting Universe is all US Equities as defined by Bloomberg. FCF/ EV stands for Free Cash Flow to Enterprise Value. FWD E/P stands for Forward Earnings to Price. B/P stands for Book to Price. Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future result.
While we do not have a crystal ball to predict which metric will best capture value going forward, we think a combination of both backward- and forward-looking metrics may make sense. By using several metrics, we seek to maintain a more consistent exposure to the value factor.
Value Portfolio Construction
When seeking to capture value, investors may want to be mindful of how much value exposure they want in their total portfolio, and how the value portfolio is constructed.
Value indexes such as the MSCI USA Enhanced Value Index and Russell 1000 Value Index have stronger exposure to the value factor as shown by their lower relative valuation ratios compared to the market.3
Valuation metrics
Source: Morningstar Direct as of 9/30/2023. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.
Source: Morningstar Direct as of 9/30/2023. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.
Value Characteristics
As shown in the chart above, the MSCI USA Enhanced Value Index has experienced lower relative price valuation ratios than the Russell 1000 Value Index. In practice, an index with lower relative price valuations has the potential to outperform a broad-based value index when value stocks do well. Conversely, indexes that have additional exposure to value will tend to underperform during challenging periods.
Another consideration for investors to be aware of is underlying sector exposures. Some sectors are prone to look structurally cheaper than others. A portfolio that simply buys the cheapest securities without considering sector allocations may have unintended sector bets. Historically, static overweight exposures to sectors have not exhibited significant long-term excess returns above the market.4 Additionally, it may be prudent to compare companies versus peers within their sector to have an 'apples to apples' comparison.
We believe sector risk is an element we can control, and that it makes sense to limit deviations. We want to find value within each sector.
The MSCI USA Enhanced Value Index applies a sector neutral constraint to its parent index at each rebalance, as well as scoring companies relative to their peers in the same sector.
Sector Allocation (%)
Source: Morningstar Direct as of 9/30/2023. Allocations subject to change. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.
It’s important for investors to understand where they may be taking risk in their portfolio. If an investor does not want to take unrewarded sector risks, it may be prudent to constrain sectors within a value strategy.
Why does value exist and why do we expect it to persist?
Value, like all factors we believe in, has an economic rationale for why it has existed historically and why we expect it to persist going forward. Value is the result of a reward for bearing risk that other investors are not willing to take (value companies can be riskier than their counterparts). Value companies have been shown to trade at a larger discount than their growth-focused peers. Further, value exists due to investor behavioral biases such as overpaying for past growth.5
Value factor strategies specifically focus on identifying companies that may be undervalued. All else being equal, if two companies generate the same profits or the same book value, we prefer to buy the one that is less expensive. The company that has the lower valuation has higher expected returns.
Conclusion
Previously, investment managers used teams of analysts to identify undervalued securities in an attempt to outperform their peers. Advances in technology have given investors additional ways to systematically identify stocks that appear undervalued. One option is using ETFs such as the iShares MSCI USA Value Factor Index ETF (XVLU) which seeks to track the MSCI USA Enhanced Value Index (CAD).
Accessing value through a low-cost ETF allows investors to gain exposure to a diversified portfolio of stocks that look strong on multiple value metrics — leverage, valuations, and earnings — and without unintended sector bets.
| Ticker | Name | Mgmt.Fee | Index |
|---|---|---|---|
| XVLU | iShares MSCI USA Value Factor Index ETF | 0.30% | MSCI USA Enhanced Value Index (CAD) |
There can be no assurance that performance will be enhanced, or risk will be reduced for funds that seek to provide exposure to certain quantitative investment characteristics ("factors"). Exposure to such investment factors may detract from performance in some market environments, perhaps for extended periods. In such circumstances, a fund may seek to maintain exposure to the targeted investment factors and not adjust to target different factors, which could result in losses.