Uncovering Value In The S&P 500: If You Know Where To Look

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Uncovering Value In The S&P 500: If You Know Where To Look

2018-12-17T17:48:42+00:00 By |

Back in 1984 Warren Buffett wrote an article for the Columbia Business Journal called ‘The Superinvestors of Graham-and-Doddsville which outlined Buffett’s value investing principles and highlighted a select group of investors who followed the value tenets espoused by Benjamin Graham and David Dodd. Warren Buffett and Charlie Munger (who’s pre-Berkshire track record was among those highlighted) may be household names, but I was surprised that I had never heard of the other “Superinvestors” featured in the article. And of the investors that Buffett features there was one in particular that caught my eye: Rick Guerin.

Rick Guerin was a very successful value investor, (who’s Pacific Partners, Ltd. generated an overall partnership compounded gain of 22,000% against a compounded gain of 316% for the S&P 500 from 1965 to 1983) and was involved with Buffett and Munger in the early days of Berkshire.  In ‘Graham-and-Doddsville’, Buffett describes his sense of Guerin:

“it is extraordinary to me that the idea of buying dollar bills for 40 cents takes immediately to people or it doesn’t take at all. It’s like an inoculation. If it doesn’t grab a person right away, I find that you can talk to him for years and show him records, and it doesn’t make any difference…A fellow like Rick Guerin… understands immediately the value approach to investing and he’s applying it five minutes later”

Most people have heard the story of Ronald Wayne, (the third co-founder of Apple who sold his 10% stake in the company back to Jobs and Wozniak for the all-in equivalent of about $10,000 in 2017 dollars). Unfortunately, it seems that Rick Guerin was the Ronald Wayne of Berkshire Hathaway, having sold his stake to Buffett in the early 70’s for $40/share (BRK.A stock price currently at ~$300,000/share represents an opportunity cost of 750,000%!!). What caused Mr. Guerin to sell his stake in Berkshire? The below quote comes from a 2013 Morgan Housel interview of Mohnish Pabrai who relayed Mr. Buffett’s response to that very question:

“[Warren said] Charlie and I always knew that we would become incredibly wealthy… we were not in a hurry to get wealthy; we knew it would happen… Rick was just as smart as us, but he was in a hurry… in the ’73, ’74 downturn, Rick was levered with margin loans. And the stock market went down almost 70% in those two years, and so he got margin calls… and he sold his Berkshire stock to Warren. Warren actually said, I bought Rick’s Berkshire stock at under $40 apiece”

Buffett’s recounting of Guerin’s undoing “grabbed” me, not as a convert to the church of Value and not as a lecture on the risk of leverage, but as a lesson on the risk of impatience and the importance of conviction. Every successful Value focused investment fund has periods of underperformance. Despite outperforming the S&P 500 by over +5,200% in the last 30 years (Exhibit 1), Buffett himself has had 5 distinct drawdowns during that period in which Berkshire Hathaway stock underperformed the S&P 500 by more than -30% (as high as -75% during the Dot com run up), often spanning significant durations (BRK.A has been in a more than -30% drawdown relative to the S&P 500 continuously from 12/1/2010 – 11/5/2018 nearly 8 full years!, as seen in Exhibit 2). All stock return data was sourced from Factset and both Exhibits cover the 30-year period from 12/7/1988 – 12/7/2018.

Exhibit 1

Exhibit 2

Standing out in Exhibit 2 above, is the recent move upward of BRK.A relative to the S&P 500. Is this the beginning of a rotation back to Value? Timing markets is difficult, but If you believe in Value as a factor and view this market as an inflection point– then take heed of Warren Buffett’s lesson on patience and conviction.

Indices That Efficiently and Effectively Access Value in US Large Cap

Below is a selection of Indices offering exposure to the Value factor within the Large Cap US equity space.

S&P 500 Value Index (SPYVx):An index of primarily large-cap value-style US stocks. The index uses three factors to select value stocks from the 500 stocks chosen by the S&P committee. Inception Date: 5/30/92

Russell 1000 Value Index (IWDx):An index of US large-and midcap value stocks. The index selects from US stocks ranked 1-1,000 by market cap based on 3 style factors. Russell 1000 inception date: 1/1/1984

MSCI USA Enhanced Value Index (VLUEx):An index of large-and midcap US equities. Stocks are selected and weighted using fundamental metrics (earnings, revenue, book value and cash earnings), aiming for exposure to undervalued stocks in each sector. Inception Date: 12/12/2014

Reverse Cap Weighed US Large Cap Index (Reverse):An index that takes the constituents of the S&P 500 and weights them by the inverse of their Market Cap. Resulting in a reverse ordering of the S&P 500. Inception Date: 10/23/2017

The risk/return data in Exhibit 3 below was generated by Morningstar for the time-period of from 12/1998 (the furthest common back-tested index date for all indices) through June 2018.

Exhibit 3

Note: Reverse has an Index launch date of 10/23/2017 and is licensed and calculated by S&P Dow Jones Indices and all information for the Indices prior to its Launch Date is back-tested by S&P DJI, based on the methodology that was in effect on the Launch Date. The same criteria hold true for the other indices prior to these live inception dates. VLUEx:12/12/2014 IWDx: Russell 1000 live inception 1/1/1984. SPYVx: 5/30/1992. Standardized performance for these Indices can be found at Reverse, VLUEx, IWDx, SPYVx.

While the above chart lays out the historical risk/return profile of these Indices, performance and volatility alone doesn’t tell us much about what is driving that performance. For that, we rely on factor analysis.

Pioneered by Eugene Fama and Kenneth French, factor analysis has become the norm of quantitative analysis for stock or Index returns. We will use one of the most popular extensions of the Fama-French three-factor model, the Carhart four-factor model (with standard monthly factor data), to compare the degree of exposure to the various factors each Index provides.

Exhibit 4

The above table shows the factor loads for Mkt-Rf, SMB, HML, MOM which represents the risk premium for Market Return, Size, Value and Momentum factors respectively, for the period in question. Focusing first on Value (HML), what immediately stands out is that the Reverse Cap weighted US Large Cap Index has a higher Value factor load than the other indices that self-identify as Value oriented.

Explaining Reverse Cap Weighting’s High Value Factor Load?

Although there are no “traditional” value screens (I.e. P/B, P/E, P/S etc.) in the Reverse Cap weighted US Large Cap Index, its robust Value exposure is a function of being a contrarian play to the Cap Weighted S&P 500. Cap Weighted Indices allocate capital to companies based on their size (essentially “Buying High, Selling Low), which by definition results in a systematic overweighting of over-valued companies and underweighting of under-valued companies. The net result of this is that S&P 500 has a natural Momentum tailwind (although sometimes stronger than others). Exhibit 5 below shows the annualized risk/return profiles for a selection of S&P 500 Indices for the 10-year period from 9/2007-9/2017.

Exhibit 5

Notice that the S&P 500 has very similar risk/return attributes to the S&P 500 momentum index over this timeframe. As we have gone through an extended market period where Growth has outperformed Value, it stands to reason that a Cap Weighted Index would display attributes of Momentum and not be currently suited to accessing Value. The systematic profit taking of Reverse Cap, through selling companies as they grow larger and allocating to those with a higher likelihood of being undervalued, drives “Buy Low, Sell High” behavior, resulting in a definitional overweighting of under-valued companies – manifesting in a high Value factor load.

This effect can also be examined empirically since both indices are calculated by S&P Dow Jones and comprised of the same underlying 500 companies. This makes it easy to compare the relative profit or loss that each Index member contributed to the respective weighting schemes as seen in Exhibit 6 below for the 10-year period of 2008-2017. All contribution data for this study was pulled from Morningstar.

Exhibit 6

Over the examined 10-year period there were 733 positions which at one time or another appeared in the S&P 500. The data to the left of the red vertical line refers to the number of companies that have contributed more profit (or less loss) to Reverse and to the right of the red line are those that contributed more profit (or less loss) to the S&P 500. This chart shows that over two-thirds of the constituents contributed more when reverse weighting, as opposed to a traditional market cap weighted scheme. This is the manifest benefit of Reverses overweighting of undervalued names and underweighting overvalued one. Where the S&P 500 benefits, is in magnitude (the skinny tail on the right). For instance, while the largest differential of any company favoring Reverse Weighting was Office Depot, with 2.75% more contribution than it did in the S&P 500. The largest differential in favor of the S&P 500 was Apple, at 7.96% more return.

Conclusion

There are currently signs in the market place that Value – a factor that has been largely out of favor since the initial GFC rebound – may finally be making a resurgence. However, timing the market is difficult and investors should take heed of Warren Buffett’s advice. Sound investment principles should lead to outperformance over time, but only if one has the conviction and patience to stick with a particular strategy. For those looking to capture the Value premium, the systematic profit taking of Reverse Cap, has shown to be an effective and efficient way to capture “Size” and “Value” within the highly benchmarked and highly liquid S&P 500 universe and even when compared to other Indices designed to be Value oriented.

Areas For Further Study

As the US economy becomes increasingly service oriented, it’s possible that traditional measures of Value (such as a low Price/Book), become less representative of the way Value acts in the real world. If there is a disassociation of Value from those underlying traditional metrics, having a strategy that carries a high Value factor load without utilizing those metrics in its Index construction, may be a beneficial tool to Value investors.

Disclosure: The Reverse Cap Weighted U.S. Large Cap Index (Reverse) is a rules-based reverse capitalization weighted index comprised of the 500 leading U.S.-listed companies as measured by their free-float market capitalization contained within the S&P 500 universe. The Index has an inception date of October 23, 2017, with a back tested time-series inception date of December 31, 1996. You cannot invest directly in an index.

S&P 500 Value Index (SPYVx): An index of primarily large-cap value-style US stocks. The index uses three factors to select value stocks from the 500 stocks chosen by the S&P committee. Inception Date: 5/30/92. You cannot invest directly in an index.

Russell 1000 Value Index (IWDx): An index of US large-and midcap value stocks. The index selects from US stocks ranked 1-1,000 by market cap based on 3 style factors. Russell 1000 inception date: 1/1/1984. You cannot invest directly in an index.

MSCI USA Enhanced Value Index (VLUEx): An index of large-and midcap US equities. Stock sare selected and weighted using fundamental metrics (earnings, revenue, book value and cash earnings), aiming for exposure to undervalued stocks in each sector. Inception Date: 12/12/2014. You cannot invest directly in an index.

The Reverse Cap Weighted U.S. Large Cap Index (the “Index”) is the property of Exponential ETFs, which has contracted with S&P Opco, LLC (a subsidiary of S&P Dow Jones Indices LLC) to calculate and maintain the Index. The Index is not sponsored by S&P Dow Jones Indices or its affiliates or its third-party licensors (collectively, “S&P Dow Jones Indices”). S&P Dow Jones Indices will not be liable for any errors or omissions in calculating the Index. “Calculated by S&P Dow Jones Indices” and the related stylized mark(s) are service marks of S&P Dow Jones Indices and have been licensed for use by Exponential ETFs. S&P® is a registered trademark of Standard & Poor’s Financial Services LLC (“SPFS”), and Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC (“Dow Jones”).

Past performance of an index is not a guarantee of future results, which may vary. The value of investments may go down as well as up and potential investors may not get back the amount originally invested. Performance figures contained herein contain both hypothetical and live returns; results, hypothetical or otherwise, are intended for illustrative purposes only. Index performance returns do not reflect any management fees, transaction costs, or expenses, which would reduce returns. Inclusion of a security within an index is not a recommendation by to buy, sell, or hold such security, nor is it considered to be investment advice. It is not possible to invest directly in an index.

The Index, strategy, and performance returns discussed are for informational purposes only and do not represent an offer to buy or sell a security and should not be construed as such.

Posted By: Josh Blechman 12/13/2018

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