There is Value in the Value Factor

Equity Factors & Fundamental Factor Valuations

September 2017. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • Equity factors can be valued using fundamental metrics
  • Value and Size are cheap while Low Volatility and Growth are expensive
  • Likely more meaningful for medium- to long-term than short-term investors

INTRODUCTION

The term “Factor Investing” reached an all-time high this year according to Google Trends, which is mirrored by an abundance of smart beta and risk premia products being issued by fund management companies and investment banks. The natural question when considering a factor product is its outlook as factors, like equity markets, can have significant, multi-year drawdowns. The likelihood of successful factor timing, again like market timing in equity markets, is probably low. However, investors still somehow need to form an opinion if the current environment is supportive for the factor outlook. In this short research note we will analyse the valuations of factors using fundamental metrics and contrast current valuations to historical averages, which is one way of determining factor attractiveness.

METHODOLOGY

We will analyse six well-known factors – Value, Size, Low Volatility, Momentum, Quality, and Growth – and use definitions close to the academic standards like Fama-French. Readers can view the precise definitions in our public user guide on our website. Factor data is available for most developed countries, but we will focus on the US, Europe and Japan as these have the largest stock universes, which make the results more meaningful. The long and short portfolios are constructed by taking the top and bottom 10% of the stock universes.

HISTORICAL FUNDAMENTAL VALUATION TRENDS

In this analysis, we will use the difference in book value multiples between the long and short portfolios to determine how cheap or expensive a factor is. This approach is equivalent of valuing stocks based on their book value multiple or other fundamental metrics. With regards to factors, the more negative the spread, the cheaper the factor as it implies that the long portfolio is trading at a lower multiple than the short portfolio, e.g. a spread of -5.0x could be derived from the long portfolio being valued at 1.0x (cheap) versus the short portfolio at 6.0x (expensive).

The chart below