WHAT IS VALUE INVESTING?

Value, like all our factor investing options, 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. Furthermore, value investing exists due to investor behavioural biases such as overpaying for past growth.²

Value strategies specifically focus on identifying companies that may be undervalued. All else 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.

Price-to-Book (P/B) takes the price of a single share of stock divided by the company’s book value per share and indicates what investors are willing to pay for a 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 and vice versa.

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.

Research by Blackrock and MSCI shows that depending on the metric used to evaluate a company’s value characteristics, an investor can have a significantly different experience. 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.

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 World Enhanced Value Index have stronger exposure to the value factor as shown by their lower relative valuation ratios compared to the market.³

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.⁴

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.⁵ Additionally, it may be prudent to compare companies versus peers within their sector to have an “apples to apples” comparison.

Sector weights

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 World 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.

Previously, active 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.

Investors also need to be aware that international investing often comes with exposure to foreign currency movements, which can have a significant impact on returns. The more volatile the exchange rate between two currencies, the higher the risk and potential impact on returns. Investors wishing to reduce this volatility, can opt for the hedged version which can help minimise unintended currency bets.

The iShares MSCI World ex Australia Value ETF (IVLU) and iShares MSCI World ex Australia Value (AUD Hedged) ETF (IVHG) allow 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.