The value factor is a way to systematically identify and invest in stocks that are perceived to be undervalued based on their fundamental balance sheets. One way to measure value is by looking at the book-to-market ratio, which compares the theoretical price of a company's equity to its market capitalization. If the ratio is high, it means the market is pricing the company's stock at a lower value than its equity, suggesting that the company is undervalued or represents a value investment. On the other hand, if the ratio is low, it indicates that the market is pricing the company's stock at a higher value than its equity, suggesting that the company is overvalued or represents a growth investment.
There are many other metrics that can be used to measure value, such as the price-to-free-cash-flow ratio, the price-to-earnings ratio, and the EV/EBITDA ratio. Value strategies often use multiple factors in their construction.
price to free cashflow
price to earnings ratio
EV/EBITDA
price to book value (terminology example: this is just the inverse of book-to-market)
The value premium is the difference in returns between value stocks (those with high book-to-market ratios) and growth stocks (those with low book-to-market ratios). The value factor has struggled in recent years as growth stocks, particularly those focused on technology, have outperformed. Some investors may be drawn to value investing because they believe they are getting a good deal or because they follow the "cigar butt" investing approach, which involves buying stocks that may have one last big run left in them.
Reasons for value factor
The value factor exists because some investors are drawn to buying undervalued stocks, either because they believe they are getting a good deal or because they follow the "cigar butt" approach, which involves buying stocks that may have one last big run left in them. In recent years, the value factor has struggled as growth stocks, particularly those focused on technology, have outperformed. This has led some investors to accumulate growth stocks regardless of their price, which has had a negative impact on the value factor.
Illustration
The value factor, as represented by the hml portfolio, has traditionally exhibited lower volatility compared to the momentum factor. The hml portfolio is constructed based on the book-to-market ratio, and goes long the highest 30% of stocks based on this ratio while selling the lowest 30%. Over the decade from 2010 to 2020, the long-short value factor had an average 1-year rolling volatility of less than 10%. However, since the onset of the COVID-19 pandemic in 2020, the volatility of the value factor has increased significantly and has been similar to the volatility of the momentum factor. This increase in volatility has also been correlated with the direction of the market, with the correlation between value and momentum increasing during the rebound in the second quarter of 2020.
The rolling 1-year volatility of the value factor compared to other style Fama-French style factors. Value (hml) and momentum, especially since covid pandemic in 2020, have structurally higher volatility than quality.
The value factor is based on price, which can make it intuitive to some investors because value stocks are often viewed as cheap stocks. As a result, their recent performance may not be as strong as their peers, leading to a negative correlation with momentum, which is based on recent performance. The correlation graphs support this idea, showing that value tends to be negatively correlated with quality and momentum. This suggests that when value stocks perform poorly, quality and momentum stocks tend to outperform, and vice versa.
The above graph shows the correlation of the long-short value factor to other Fama-French style factors (hml, smb, and mom) over a 2-year lookback window. This graph illustrates how the value factor has moved in relation to these other style factors over the past two years. The correlation coefficient (a value between -1 and 1) indicates the strength and direction of the relationship between the two factors. A positive correlation means that the factors tend to move in the same direction (e.g., both increase or both decrease), while a negative correlation means that the factors tend to move in opposite directions (e.g., one increases while the other decreases).
When is the value play?
The long-short value factor had a difficult decade from 2010 to 2019, leading to questions about its continued relevance within the quantitative investment community. However, since the onset of the COVID-19 pandemic in 2020, the value factor has had a strong two years, returning over 30% since January 1, 2020. Long-only value stocks have also significantly outperformed the broader market.
Value tends to do well in the aftermath of a recession or during periods of inflation, and may focus on defensive sectors such as utilities and consumer staples. In contrast, value tends to underperform during the mid-to-late stages of a bull market, when growth stocks tend to outperform. This has been the case during periods of exuberance, such as the tech bubble preceding the financial crisis and the post-crisis recovery.
Value factor performance against other Fama-French style factors, time period 2010-2022
The following graph shows the performance of the Fama-French style value factor, which is a long-short, market-neutral factor based on a book-to-market metric. This simple value metric is used to compare the spread of yearly returns for value versus quality. The plot illustrates that over the past 15 years, value has been significantly more volatile than quality. This suggests that the value factor has experienced greater fluctuations in performance compared to the quality factor over this time period.
Value factor yearly performance paths since 2010, long-short market neutral construction. Black line with red dot is performance in 2022 so far.
After underperforming for much of the 2010s, the value factor has had a strong rebound in the last two years. It has been the best-performing factor over this time period and has continued to match this performance so far in 2022. If this trend continues, the value factor could return 20% during the year.
There is speculation that the resurgence of value has further room to run and could continue for the decade starting in 2020. This is because the strong performance in 2021 and 2022 has only partially made up for the losses of the previous decade. However, it is important to note that past performance is not necessarily indicative of future performance and there are no guarantees that the value factor will continue to outperform in the future.