Hunting for Value In A Falling Market

Today, we’re going to wrap up our series on Value in the real-life context of a massively volatile and beaten down market.

We’d like to start by noting that after the turbulence of the past few weeks, our Global Market factor is flagged as “Extremely Oversold” at -2.9 standard deviations below the mean:

While conditions still seem to be normalizing, a good deal of fear and concern abounds - and we’re certainly not calling an end to the volatility. As far as we know, it might take months for us to fully understand the economic and market ramifications of the COVID-19 outbreak that led the Fed to cut rates by 50bps on Tuesday.

We do, however, think this represents an opportunity to take a beat and see if there’s a buying opportunity for Value-hunting in this market.

As we discussed two weeks ago, Value has become “polarized” as the exposure spread between high-Value and low-Value names has widened for fundamental factors like Earnings Yield, Growth, Profitability, and Dividend Yield. Another key observation we made is that Value exposure by sector has become increasingly top heavy, with Banks, Insurance and Energy comprising a great deal of all high-Value names. Here is what sector exposure has looked like for the top quartile of Value names over the past decade, with the most recent exposures broken out in the table on the right side:

‍Top 5 Sector Exposures: Value - Top 2K - Top Quartile (2010 - 2020)

This chart shows us how the top quartile of Value names have really been driven by financials, with exposure to Banks nearly doubling over the past decade. We also see that Insurance was the biggest sector earlier on, although it has come down over time. Equity REITs have seen an increase as well, although they peaked in 2018 and have since fallen a bit. Oil & This portfolio’s exposure to Oil & Gas names also nearly quadrupled in 2015, with the industry remaining a top 3 exposure.

So, if an investor thinks the market is oversold and is looking to buy a basket of Value names, they could very easily be in a position where their Value screener gives them a list of names like the above which is vastly overweight Financials and Energy. This defeats the purpose of trying to be thoughtful and diversified in our investment approach and adds a good deal of industry risk.

The question then becomes, can we construct a basket that provides sector-diversified exposure to “cheap” names?

‍Building a Sector-Agnostic Value Portfolio

‍In our post on value on February 16th, we applied the following process to build a Value-focused portfolio:

1) We leveraged our Security Search tool to screen for the top 2000 stocks by market cap in our US model universe, and ranked them from high-to-low based on their Value (book-to-price) factor exposure.
2) From that list, we created an equally weighted portfolio from the top 500 stocks with the highest Value factor scores. We called this portfolio: Value - Top Quartile.

‍This week, we adjust part (2) of the above process to create a ~500 stock sector agnostic Value portfolio as follows:

• Across the 68 GICS Industries (GICS3), we select the top eight names by Value exposure from each GICS industry, and create an equally weighted portfolio of 544 names. We call this portfolio: Value - GICS3 Diversified.

Here’s how the current sector exposure of the new portfolio measures up against the original Value - Top Quartile portfolio:

Through this adjusted selection process, we were able to effectively neutralize the excessive exposure to Banks, Insurance, and Oil & Gas, while adding exposure to industries like Internet Software and Life Sciences (industries one might not typically assume would be found in a Value portfolio).

Here’s what Value and Growth exposure looks like for the Top Quartile basket vs. the GICS3 Diversified version:

‍Exposure: Value - Top Quartile vs. Value - GICS3 Diversified (2010 - 2020)

Obviously, when removing many of the names (i.e banks) from our Value basket, we’d expect to see Value exposure come down. We also see that exposure to Growth has remained fairly consistent between the two. Thus, we see that by using the diversified basket we are still able to create a Value vs. Anti-Value play, without sinking a disproportionate amount of dollars into the top Value sectors. Next, we’ll see how these baskets have performed.

‍Performance: Value - Top Quartile vs. Value - GICS3 Diversified (2010 - 2020)

The Value - Top Quartile basket slightly outperformed Value - GICS Diversified over the past decade, although the difference in annualized returns was a meager 13bps. We also see that the diversified version was far less volatile (with nearly 6% less annualized vol). We also note a higher Sharpe in the new basket, as well as a lower max drawdown. Most importantly, we were able to accomplish this without taking on any outsized industry bets.

‍Sector Contribution to Performance: Value - Top Quartile vs. Value - GICS3 Diversified (2010 - 2020)

If we look at just sector contribution to performance, we can see that the diversified basket outperformed the top quartile by nearly 29% over the past decade. This is because exposure to Oil & Gas was taken down, while exposure to sectors like Biotech was also taken on.

Ultimately, it’s up to each investor to decide whether its time to start buying stocks or wait to see what lies around the bend. Here, we hope to have shown how easy it is to use Omega Point to create a thematic basket of stocks without incurring large, unintentional sector bets. It’s our belief that a well-rounded, sector-neutral Value portfolio can help you better capture Value without taking on a big sector tilt.

US & Global Market Summary

US Market: 2/28/20 - 3/05/20

• The market saw continued volatility amid concerns about the spread of COVID-19 and its economic impact, with upwards of 100k cases being announced worldwide and cases being reported in 21 US states. Weakness at the open on Friday (not captured in above chart) gave way to a late day rally, which resulted in the S&P 500 ending the week only flat to slightly down.
• The Fed cut interest rates by 50bps in an emergency rate move, which gave the market 15 minutes of optimism before it continued to plummet as investors sought the safety of bonds and wondered what data the Fed had seen to make such a decision.
• After Friday’s continued pain and a new record low in Treasury yields, the market is now pricing in a 65% of a 75bps cut in the mid-March FOMC meeting.
• The US passed a $8.3 billion emergency spending bill in hopes of improving testing capacity among other measure to contain the outbreak.
• The February jobs report contained an upside surprise, with +273k in non-farm payrolls vs. an expected 175k. The unemployment rate was back at a 50-year low, although these numbers obviously don’t yet reflect the impact of COVID-19.

‍Factor Update: Axioma US Equity Risk Model (AX-US4)

• Value continued to see slight improvement as it crawled 0.06 standard deviations closer to the mean.
• Size saw some recovery after last week’s tumble, up +0.23 SD above the mean
• In another week defined by a flight to safety, Profitability continued to see strength, moving to +0.24 standard deviations above the mean.
• Market Sensitivity continued to slide, now sitting on the cusp of an Extremely Oversold designation.
• Growth was the biggest loser this week, as it fell out of Overbought territory and now sits at +0.69 SD above the mean.
• US Total Risk (using the Russell 3000 as proxy) rose 38bps over the past week after last week’s huge upward move.

‍Factor Update: Axioma Worldwide Equity Risk Model (AX-WW4)

• Earnings Yield was the biggest winner internationally, up 0.32 standard deviations as it headed back to the mean.
• Size also saw a fairly strong upward move, and is nearing an Overbought label as it sits at +0.89 SD above the mean.
• Unlike the US, worldwide Value saw weakness on a normalized basis, falling to -2.42 SD below the mean.
• Market Sensitivity and Volatility both experienced continued weakness, with Volatility earnings an Extremely Oversold designation at -2.18 SD below the mean.
• Growth was the biggest loser again, falling 0.33 SD but still sitting at +1.51 SD above the mean.
• Global Risk (using the ACWI as proxy) saw a very slight decrease after peaking at 13.27% on 3/4.

Regards,
Omer