FTSE Russell Convenes | Episode 12, Season 3

Value's U-turn

November 1, 2023

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Rob Arnott, Founder and Chairman of Research Affiliates joined us for our FTSE Russell Convenes series in June. In this episode he predominantly focuses on value, paying particular attention to how it should be valued, not only in terms of market valuation, but also in terms of factor inputs. Rob also inevitably discusses style rotation and the products born out of the relationship with FTSE Russell. 

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We did a research project asking has value in fact died.Has it died are the critics, right?So Rob, I do want to get on and talk aboutresearch affiliates and the products you have on offer.But before we do that, we've spokenabout growth versus value before,and myself included, there was many of uswho felt that growth had had its time in the sun.And with higher rates, this was going to bea period for value to outperform.We have got the high rates.It appears that they are going to be here for a while,but still there's a lot of tailwinds in growth.I'm just wondering if I can avery narrow sliver of growth.Big players, but a small number of names.So actually what we're doing thereis we're talking about growth as a whole,but it's just a handful of the invidias ofthis world that are just takingthat full segment of the market with it.I read the other day that the five most successful stocksthis year in the S&P we'rethe only reason it's up year to date is that right?I haven't seen that mask before, but that might be right.Yeah, Yeah. Value went throughthe longest and deepest dry spell inhistory in from 2007 to summer of 2020.Depends how you define value.If you define it on price to book,it was the full 13 years.If you use price earnings,it was 2013-20 If you use price to sales, 2017 to 20.Either way, it's a long, dry spell.In the 2018 to 20 period canonly be described as a value crash.Underperforms severely Now as a value investor,obviously that puts our company through a ringer,and it has us challenging andtesting our own assumptions.We wrote a paper back atthe beginning of 2021 in the FAJ.It got Graham and Dodd recognitionas one of the two best articles of the year.The paper was entitled, Reports of Values.Death May Have Been greatly exaggerated.The basis of the paper was wedid a research project asking has value in fact died?Has it died? Are the critics right?What we looked at, among other things,was the spread invaluation between growth stocks and value stocks.Now if you use a classic pharma French formulation,you're using price to book In 2007,the spread in price tobook growth stocks inthe value stocks usingRussell growth and Russell value for instance,was four to one.Growth stocks are moreexpensive, They're better companies.They deserve a premium multiple.But how much of a premium is the key issue?That went to 131 by the summer of 2020.It only reached ten to oneat the peak of the tech bubble.This was tech bubble on steroids magnified.Now what's interesting isthat Russell value peak to troughunderperformed Russell growth in terms ofrelative performance by 3,700basis points over that 13 year span,Russell value got cheaper relativeto Russell growth by three to one.If it's 67% in relative cheapness anddown 37% in relative performance,then that means the underlying fundamentalshave actually been improving relative to growth.I'm actually going to show an exhibitthat shows this vividly.The dividend stream of a Russell value portfolio,2007-2022 has risen fasterthen the dividend stream of a Russell growth portfolio.Really? It's not because the value stocks grow faster,it's because of what Fama andFrench called the migration effect.Value stocks, the value portfolio,you have individual stocks that percolate out of it,suddenly get recognized as,oh, this company is not so bad.After all, they're kickedout and replaced with deep value stocks.If you replace a stock with an earnings yield of five,PE ratio of 20, with one,that's earnings yield of ten,PE ratio of ten,then you're boosting the earnings base.Boosting the dividend base,the book value base every time you rebalance.It's called a migration effect becauseit relates to migration in and out of the list.The growth portfolio has the opposite stocks that areremoved from growth almost alwaysbecause they fall into too cheap evaluation.If you replace a stock with a PE ratio of let's say 15,with one with a PE ratio of 30,you're reducing the income stream, The dividends,the book value ofthe growth portfolio net of the migration,inclusive of the migration effect,I should say the dividend stream for value,the book value for the value portfolio all grewfaster than for the growth portfolioduring the period of time when value was getting crushed.Which means if the relative PE ratio,relative price to book hadstayed steady for those 13 years,value would have been growth.We pointed this out. We also pointed outthe deep flaws of using conventional book value.The result was a pretty compelling casethat value stocks were doing badly,but value companies were doing fine.Now markets move because of narratives.The narrative was with the covid lockdowns.These tech companies are beautifullypositioned for a world in which people work from home.In which people don't interact as readily as they usedto a word in social interactions are going to change.The way you buy and sell goods isgoing to change and the list goes on.By the way, the bricks and mortar companies,their toast, you're going to see rolling bankruptcies.Lo and behold, with stimulus checks,paired with a non permanent pandemic lockdown,we found that the value stock survived just fine.Bankruptcies in 2020 were up modestly from 2019.Shocking that it was only a modest jump.Yeah, the result was,instead of the market was sayingthese value companies are going todo terribly as businesses,the reality was they were doing fine.The snap back issomething that we were predicting in the paper.What we weren't predicting wasthe current snap back in growth year to date.This year, that's on the back of AI.The narrative today looks an awful lot to me,like the narrative of the year 2000.Back then you had Internet will change the world.It's a new paradigm.Pay no attention to profits ordividends because they're irrelevant.These companies are goingto take over the way we do everything.Now the narrative is that AI will do that.Rob, if you could explain to methe partnership products you have with FTSERussell and RAFI. FTSEembraced the fundamental index concept.Way back in 2005,we brought the idea to foot at the suggestion of Calpers.Helpers wanted to embrace the idea.FTSE was the index provider for Calpers.Obviously, we had high oddsof a near term immediate client.FTSE embraced the idea, ran with it,and it became a major profit engine.Russell came to us and said,we're going to launch similar product.Do you want to work with us on it?My original agreement with FTSEhad given a three year exclusive.This was six years. I said sure,but it has to be different.They initially wanted it to be a clone and I said no way.So we created a complimentary,somewhat different but think of it as first cousins.FTSE of course, bought Russell and now they'reall under one roof FTSE Raffi and Russell RAFI.And upwards of 100 billion managed using them.I'm right in the same performance has beenpretty great since Covid,Not since Covid, since the launch of RAFI.To the casual observer,RAFI had a challenging decade in the 2010.But keep in mind,cap weighted indexes studiouslymirror the look and compositionand performance of the stock market.By definition, that momentum plays,but relative to the economy their momentum plays,their growth plays their popularity weighted indexes.Yeah, RAFI is studiously neutral relativeto the publicly traded macroeconomy.It weights companies according to how big isthe current economic footprint rightnow relative to the economy.Cap weighted indexes aregrowth portfolios relative to the market.Raf is a stark value portfolio.You can do a Fama French attribution and lookat the alpha neta Fama French.Or you could play it super simply and just say, okay,the value tilt of RAFI roughly equalsthat of the conventional value indexeson average over time.It's dynamic. When value is underperformed,we have a deeper value tilt than valuewhen value is relatively fully priced.As it was in 2007,we have a pretty skinny value tilt,but on average aboutthe same value tilt as value indexes.The tracking error of RAFI Global against Ftse,all world is 5% against all world value,it's 2.5% if youlook at it relative to the value indexes,what we find is since the launch ofRAFI during periods when value was winning,during periods when value was losing,during the value crash as it was happening,we beat the value indexes byan average of 1.5 to 2% per annum.Now for 18 years with 2.5% volatility. That's great.So it's already got a T statistic of threeplus these indices have been stupendously effective.The challenge in the last decadehas been a marketing challenge.People will inherently compareit with the cap weighted markets.Whenever value is losing,we may be losing by less, but we're still losing.Yeah, when value is winning,we're winning by more.We're perceived as heroicallyhitting the cover off the ball.Now, how long can that continue?If you compare it to the value indexes you findit's just relentless, right?I have one final question.You said earlier, Rob, that you wrotea paper talking about the valuation metric price to book,how you didn't think it wassuch a great metric to look at, am I right?It's flawed. It's okay.It's not a bad metric.But book value wasdefined either early 20th or late 19th century.The reason I'm asking is I'm wondering if now is therea better way to value stocks?Oh, absolutely.We use a composite of measures.If you look at price to sales,price to book price to cash flow,price to dividends plus buybacks,these are all good measures and they are all flawed.George Box of Box Jenkins famewas fond of remarking that all models are wrong.Some models are useful.Oh, I wish the quant community andthe economics profession would embrace that.Everything we do in the quant community,everything that's done inthe economics community isbased on models that are wrong,but some of them are useful.Find out which ones are useful, use those.The pitfall with book valueis that it leaves out all intangibles.We've all heard the cliche thatour assets go up and down in the elevator every day.Yeah, that is true of about half of all businesses today.The old bricks and mortars businesses.A department store, it's not as true,The assets are the people for sure,but also the buildingand the product that they're selling.And that's a big sunk cost.Book value measures that.Now what if you takebook value and when a company invests in R and D,you add it to the book value and amortize it out.If I spend five grand on a nice desk,it goes right on the balance sheetas an asset, it's amortized out.If I spend 5 million on R and D,it's treated in accounting land as if it wasjust a discretionary throwing away or burning of assets.Now, I don't spend that on R and D.If I think it's going to come back,think of it like a desk,add it to the book value, amortize it out.If after ten years ithasn't paid for itself with room to spare,then it was a dumb idea.Same as a desk you turned out not to have needed.When you do that, FrenchPrice to book the value investor.Today is five times aswealthy as the growth investor from 60 years ago.If your grandparents bought Fama French value,their next door neighbor bought Fama French growth,you would have inherited a portfolio that's worth fivetimes as much asthe descendants of the next door neighbor.All right, well, that's great.If you threw in just R and D,nothing else, just R and D,you would have ten times as much money price to book,can be made roughly twice aseffective for the long term patient investor.By incorporating R and D,you can also incorporate a portion ofthe administrative side tothe extent that somebody spends money on patents,on brand building, through advertising, and so forth,those expenditures are justifiablytreated as investments and therefore added.But that's trickier because that'sin baskets that also include ordinary operating expense.So the one piece that is easy to carve out and say,well, this is investment is R and D.That was in that same paper.It really could have been two papers,but it was a two.Yeah. Well, such an importantthing to discuss right now aspeople try to workout whether stocks are overvalued or not.Rob, it's been so fantastic chatting to you.Thank you so much for your time.It's always such a great conversation.Well, I have thoroughly enjoyedthis nearly two decade longpartnership and I look forward to many years to come.Thanks, Rob.

Video recorded on June 05, 2023 at FTSE World Investment Forum

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