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Robust returns for value stocks in 2016 highlighted why patient investors may benefit from the RAE Fundamental strategies’ contrarian approach. But with a return to growth testing value investors this year, it’s worth remembering how the RAE strategies may benefit from these market reversals.
In this Q&A, Research Affiliates’ Chairman Robert Arnott and CIO Christopher Brightman, portfolio managers of the PIMCO RAE Fundamental strategies, provide perspective on how periods of underperformance for value are part and parcel of these strategies’ contrarian approach – and why a painful 2017 for value thus far may position investors for future returns.
Arnott: Clearly, 2017 has been a painful year for value investors. In any given year, the odds that value will outperform growth are basically a coin toss,1 but even so, the magnitude of value’s shortfall this year is unusual: The Russell 1000 Value index has lagged Russell 1000 Growth by more than 12 percentage points (at 7.9% versus 20.7%). It isn’t fun to stick with a disciplined, value-based approach when prices for the “FANMAG” stocks (Facebook, Amazon, Netflix, Microsoft, Apple and Google), along with niche fliers like Tesla, seem to go up every day.2
But there’s a real and meaningful silver lining: Value is now historically cheap relative to growth, particularly outside the U.S. We would not necessarily expect such a short period of poor returns from value to presage an immediate recovery (though that’s certainly possible), and we do not have a crystal ball to tell us how the rest of 2017 will play out. But history has shown that investors have often been rewarded for sticking with value after experiencing periods of underperformance. Following short periods (i.e., six months) when value lagged growth by more than 9 percentage points, the average subsequent recovery in value, relative to growth, was 18% over the next three years. And that’s for the index (Russell 1000 Value), not for the RAE strategy. Because RAE trades into a deeper value tilt as value underperforms, the rebounds have the potential to be even stronger for RAE.
Meanwhile, growth companies that were expensive entering 2017 have only appreciated further. Last year we wrote a series of papers examining the powerful relationship between valuations and subsequent returns.3 While value stocks by definition trade at a discount to growth stocks, the magnitude of that discount changes over time, and it has become steeper this year according to the methodology outlined in these papers.4 Prices of value stocks ended 2016 at 28% the price of growth stocks, slightly above the long-term median of 27.1%, but have since fallen below the median, to 24.8%.
Figure 1 shows nearly a half-century of performance for value stocks relative to growth stocks (in blue), along with the valuation of value relative to growth (in gold), highlighting the strong link between valuation and return. Importantly, value has outperformed growth net of valuation changes – hence the “wedge” between the chart’s blue and gold lines. A dollar invested in 1968 in a hypothetical portfolio that is long the value stocks and short the growth stocks would have grown to more than $2.50 at the end of June (does not include the impact of fees and would be lower, if applied), despite compression in valuations of value stocks relative to growth.
We view this spread between returns and valuation as a kind of “structural alpha”: While returns and valuation are closely related, value investing may generate an additional premium over and above valuation changes.
If history is any guide, while 2017 has been challenging to date, the period has created an opportunity for disciplined value investors with long-term horizons. RAE has taken on a deeper value tilt now – after value has become cheaper – than it had a year or two ago. That’s part of the potential power of the strategy.
Our long-term investors know that what makes the RAE strategy special is, in part, that it seeks to trade into the drawdowns, patiently and gradually, in an effort to earn back the shortfall in value with potentially room to spare. And while history is not a precursor to future results, it has shown that these drawdowns can be essentially a coiling of the spring: The snapbacks have often been fast and sizable. These excess return opportunities have been possible because of the drawdowns, which have set the stage for bigger recoveries, and not because of steady-state markets in which we add value slowly and steadily.
Of course, one core attribute of RAE is its value bias – sometimes modest, sometimes deep. When value struggles, so do returns for RAE. We then trade into a deeper value tilt, so that when value recovers, we will be positioned to potentially earn back the shortfall, and then some. Then we trim it again. As they say, “rinse and repeat.”
Brightman: A brief review of our RAE strategy helps further explain how periods of underperformance position RAE for future returns.
We employ a systematic active investment process built upon a foundation of contrarian rebalancing. To seek to capitalize on long-horizon mean reversion, we rebalance the weights of the stocks in these portfolios back to the relative economic size of the issuing companies. We augment this simple rebalancing by adjusting the anchor weights to which we rebalance to reflect the quality of the business. We then measure momentum to improve the timing of our trades and seek to avoid catching “falling knives” or selling winners too quickly.
Since launching our contrarian RAE portfolios in 2004, we’ve experienced a number of shortfalls for value similar to what we’re seeing this year. During short-term periods when growth was handily outperforming value, RAE failed to keep pace with the market. But the other side of this coin is a wider valuation discount for RAE – setting the strategy up for subsequent periods of strong outperformance (see Figure 2).
Similar to what Rob noted above for value stocks more generally, the RAE strategies have shown strong relationships between relative valuations and subsequent returns (see Figure 3) – no surprise, given our disciplined contrarian approach. And this relationship holds globally, across the U.S. and emerging markets portfolios.
Our inherently contrarian RAE methodology calls for buying more value when value is deemed to be “cheap,” thus enabling us to potentially generate excess returns even during long periods of underperformance. We have generated excess returns since inception after fees in the U.S. and emerging markets RAE portfolios despite underperformance from value in each region (see Figure 4).
We are excited to see the excess returns RAE may generate when value returns to favor and this headwind becomes a tailwind.
Founder and Chairman, Research Affiliates
Chief Executive Officer and Chief Investment Officer, Research Affiliates
London PIMCO Europe Ltd 11 Baker Street London W1U 3AH, England +44 (0) 20 3640 1000
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Past performance is not a guarantee or a reliable indicator of future results.
A word about risk: Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Commodities contain heightened risk, including market, political, regulatory and natural conditions, and may not be suitable for all investors. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. Derivatives may involve certain costs and risks, such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Investing in foreign-denominated and/or - domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Sovereign securities are generally backed by the issuing government. Obligations of U.S. government agencies and authorities are supported by varying degrees, but are generally not backed by the full faith of the U.S. government. Portfolios that invest in such securities are not guaranteed and will fluctuate in value. High yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Mortgage- and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government-agency or private guarantor, there is no assurance that the guarantor will meet its obligations. Income from municipal bonds may be subject to state and local taxes and at times the alternative minimum tax. Swaps are a type of derivative; swaps are increasingly subject to central clearing and exchange-trading. Swaps that are not centrally cleared and exchange-traded may be less liquid than exchange-traded instruments. Inflation-linked bonds (ILBs) issued by a government are fixed income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Treasury Inflation- Protected Securities (TIPS) are ILBs issued by the U.S. government. Certain U.S. government securities are backed by the full faith of the government. Obligations of U.S. government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the U.S. government. Portfolios that invest in such securities are not guaranteed and will fluctuate in value.
The terms “cheap” and “rich” as used herein generally refer to a security or asset class that is deemed to be substantially under- or overpriced compared to both its historical average as well as to the investment manager’s future expectations. There is no guarantee of future results or that a security’s valuation will ensure a profit or protect against a loss.
References to specific securities and their issuers are not intended and should not be interpreted as recommendations to purchase, sell or hold such securities. PIMCO products and strategies may or may not include the securities referenced and, if such securities are included, no representation is being made that such securities will continue to be included.
The MSCI All Country World Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. The Index consists of 46 country indices comprising 23 developed and 23 emerging market country indices. The MSCI All Country World ex US Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. The Index consists of 45 country indices comprising 22 developed and 23 emerging market country indices. MSCI EAFE Index is an unmanaged index designed to represent the performance of large and mid-cap securities across 21 developed markets, including countries in Europe, Australasia and the Far East, excluding the U.S. and Canada. The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. Russell 2000® Index is composed of 2,000 of the smallest companies in the Russell 3000 Index and is considered to be representative of the small cap market in general. S&P 500 Index is an unmanaged market index generally considered representative of the stock market as a whole. The Index focuses on the large-cap segment of the U.S. equities market. It is not possible to invest directly in an unmanaged index.