Copyrighted by ISS EVA and reprinted with permission by ISS EVA. PDF available here and webinar here.
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Understanding Factor Rotations is Paramount to Managing a Firm
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There’s been a debate in the profession and in academia for decades over whether growth or value outperform. Several seminal papers by Fama and French in the early to mid-1990s showed that value was the clear winner, then the late 1990s were a time for growth, next value dominated during the first decade of the 2000s only to be taken over by growth in much of the 2010s. Today, value is outperforming. The periods of growth or value superiority are not random.
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My career was greatly influenced by the internet bubble of the late 1990s when I was assistant portfolio manager (PM) on a value fund when anything that was reasonably valued underperformed. Soon afterward, I became PM of a core S&P 500 benchmarked fund and director of research (DOR) with analysts providing ideas to growth, value, large, and small portfolios. As DOR, I needed to wear all style hats, but was quite excited about the massive rotation back to value starting in early 2000.
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Since this time – out of necessity of managing a firm and interest – I’ve been studying “when” value and growth work. “When” is the key question. I even put my career on the line when I joined a quality-growth firm as a portfolio manager in 2004 in part because it was underperforming, right on schedule, coming out of a recession. Having studied these cycles for a few years, I put my theories to test and concluded that this firm’s fortunes – if it did nothing to change its quality-growth approach – would eventually improve. Much like sectors rotate over the cycle based on their defensive, growth, and cyclical attributes, I found that value and growth styles of investing do as well. Styles of investing, like sectors (and even asset classes), have factor exposures – risk, growth, profitability, and valuation profiles – that cause them to behave in predictable patterns based on macro conditions.
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Many may believe the key to success as a portfolio manager is simply picking great stocks. While good stock picking is quite useful, a portfolio manager must also have a rigorous, repeatable, and consistent investment philosophy and process, understand and appreciate cycles, and have excellent risk and performance management.
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An investment approach (or style) includes a philosophy and process. To me, a philosophy of investing should be summed up in a short statement. For instance, for value it could be “I believe in reversion to the mean which means that poor performing firms fix themselves over time, so stocks that are priced for failure should outperform.” For GARP (growth-at-a-reasonable price), it could be “I believe quality firms that reinvest in their business will grow and the stock will appreciate with that growth if it is reasonably valued.” The process that follows the philosophy statement includes all the details that arise from the philosophy that are necessary to manage the portfolio: the screens, who covers which sectors, risk controls (max sector and stock weights and over- and underweights), the sell discipline, etc. A screen that follows from a philosophy focused on companies “priced for failure” could be a P/B ratio < 1 (or MVA Margin of < 0) or something similar. A screen for a GARP philosophy may include return on capital (ROC), economic value added (EVA), a measure of growth, another for risk, etc.
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As this paper shows, cycles determine when different factors work best. You could have a portfolio of great stocks, but if the cycle goes against you, good luck generating alpha. Four macro conditions drive when growth and value work: (1) overall economic growth, (2) interest rates, (4) the valuation discount between value and growth (versus their relative fundamentals), and (3) equity returns. You might say, “I have a value benchmark and I manage a value portfolio so these things shouldn’t matter.” Do you have exactly the same valuation multiples as your benchmark? Is your ROC the same? If not, then you have style factor risk exposures, and the cycle still matters to your alpha. Of course, factor exposures can impact the performance of your benchmark relative to others, but they can also impact your performance relative to your benchmark.
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Figure 1 shows the information coefficient (IC) of various drivers of business success – ROC, EVA Momentum, and EVA Margin volatility – and valuation (MVA Margin or MVA/Sales) with US stock returns. If the IC is negative, this means a lower ratio is associated with higher stock returns, and vice versa. In general, lower valuation and lower EVA Margin volatility are better, but there are exceptions when high valuation and high volatility are positively related to returns. Conversely, high ROC and EVA Momentum are normally correlated with stronger returns, but there are times when the opposite is true as well.
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Given that cycles have so much influence on returns, one could argue that it isn’t wise to have a consistent philosophy and process. One may say that it is best to modify the philosophy and process if one can successfully predict phases of cycles. However, if you modify your portfolio on purpose based on your understanding of macro conditions, then I’d argue that you are not modifying its philosophy and process at all since top-down macro analysis is part of it.
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I’ve argued over the years that one needs a consistent, well-founded, repeatable philosophy and process. You must truly believe in it to be able to stick with it during the rough times, or you may abandon it when the pain is greatest and when the headwinds of the cycle are about to change to tailwinds. Unfortunately, due to many behavioral biases and client pressures, people tend to be reactive instead of proactive, so most abandon their approaches only after underperformance, at the worst time just before conditions are about to change. I became a DOR in 1997 and watched the $7 billion value fund go through the roughest headwinds. It abhorred technology, except for Apple and AMD, which were two of its largest positions. It owned utilities, gold (my idea), and other cyclical old economy companies. The client unfortunately did not understand the cycle like most people, so management was encouraged to abandon the fund and it was, in essence, liquidated in the first quarter of 2000. The timing couldn’t have been worse – it was a $3.5 billion to $7 billion mistake – as the internet bubble burst in about April that year. Utilities outperformed, and over the next decade and beyond gold rose from under $300 to $1,600+ and Apple and AMD made history.
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If you’re a bottom-up stock-picking investor, it’s best to be consistent and have an excellent risk management system so you can identify whether the cycle or stock picking are driving the under- or outperformance. If the cycle is the cause of underperformance, then it will help morale and client retention (if communicated) to know the performance is not due to poor stock selection. This knowledge may help keep you true to your philosophy until it returns to being in style. If the cycle leads to your outperformance, then knowing this will keep you humble and not overconfident, which is one of the most problematic and well-documented behavioral biases that can lead to too much risk taking and failure.
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I hope you do not have to experience what I did in 2004-5, but maybe my story will help you if you do. Remember, I joined a bottom-up quality-growth investment firm as a portfolio manager in 2004, and I was also helping build its process. 2004 was a time when the economy was rebounding. The investment team’s morale was low, and this created disagreements which were quite disruptive. One fellow portfolio manager (he was eventually let go) was probably the biggest problem despite his good performance, since that performance may have made him too confident. He dismissed anything macro. In the early 2000s, the cycle’s impact on value and growth were barely understood, so he did not like it when I showed in my first month how the portfolios’ alpha to their benchmarks varied inversely with the economy. Being macro-aware would have really helped that bottom-up team weather the storm of underperformance and the pressures and problems it creates. To be bottom-up and to not be impacted by the cycle requires either eliminating factor exposures (e.g., having the exact same ROC as your benchmark) or having a complete cycle as a time horizon, which in this business is rarely allowed due to pressures to consistently perform each year. Those pressures and incentives also caused the incoming CIO to push for more yield in stock and bond portfolios (current income = earnings), but it also meant more risk. I left the firm in early 2006 and met the outgoing CIO for lunch every six months in 2006/7. We agreed that it would blow up, which it did with the financial crisis. Failure to understand cycles is dangerous, even for a bottom-up investor.
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The Cycle
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The cycle I am referring to is multi-faceted. As noted above, it includes economic growth, but it also considers interest rates, market returns, and the valuation discount between value stocks relative to growth.
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Generally, as the economy improves interest rates rise and market returns are positive (figures 2-4). The reverse is also the norm. Sometime late in the upcycle, valuations become stretched as momentum takes over.
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These are generalities. Due to the Fed being late to address inflation, in 2022 rates are rising as the economy is slowing. This can be seen in figure 3 where rates are rising despite the ISM PMI rapidly decelerating.
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Figure 5 shows that after a period of strong economic growth and good returns, valuations for the most expensive stocks becomes stretched. Investors who failed to join earlier often jump on the bandwagon, not wanting to be left out of the party. Oftentimes, individual investors add to equities at this time, but if they don’t understand the fundamentals of valuation, they may gravitate to the “story” stocks: that is, IPOs and other great growth stories. Momentum overtakes markets, where the winners of the past keep rising to a point where expectations become too high. In the current cycle, valuations became very stretched in 2021 when IPOs, SPACs, and cryptocurrencies were the rave. Eventually, markets correct, which occurred this year as the economy rolls over. The high beta Renaissance US IPO index is down 51% this year through November 1 versus 18% for the overall market. The private owners who sold their companies at highs are the smart money investors.
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Factor Rotations: When Do Growth and Value Outperform?
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(See When Do Value and Growth Outperform? on my Coach Investing website for an earlier paper on value and growth rotations using traditional valuation ratios. I’m Dr. Spellman, but everyone calls me Coach as I coach investing and love it.)
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Economic growth, interest rates, the valuation discount of value versus growth, and market returns impact the style rotation. These four variables impact and/or relate to the components of the value equation – profitability and growth, the discount rate ignoring risk, the relationship of valuation to profitability, and risk (see box 3). Value is favored in an accelerating economy, when rates are rising, when market returns are high, and when the valuation discount is high.
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Figure 6 highlights value/growth performance during environments characterized by change in economic growth, interest rates, and market returns. The results are from sector-neutral sorts to eliminate the impact macroeconomic forces have on sector rotations and to allow us to focus more on company-specific factor risk exposures.
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Box 1 shows that sectors have huge sector over- and under-weights. Although, since companies can have the same factor exposures as sectors, sorts across the entire universe provide similar conclusions. Alpha in figure 6 is shown for quintile sorts based on valuation (MVA Margin), growth (EVA Momentum), profitability (EVA Margin and ROC), and volatility (EVA Margin volatility). See equation 4 in Box 2. Theoretically, MVA Margin – the amount the market value of a company trades above its book value as a percentage of sales – is positively related to growth and profitability and negatively related to volatility. In the next section, I provide the empirical evidence for these relationships. So, please think of high-MVA Margin companies as “growth” and “quality” companies (based on high profitability and low risk).
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The second column of figure 6 shows that, overall, low-value (low-MVA Margin), high growth (high-EVA Momentum), high profitability (high-EVA Margin and high ROC), and low volatility (low EVA Margin volatility) stocks outperform. The remaining columns show that this performance is highly dependent on the macro environment.
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With quarterly data, there were 77 forward 12-month periods from June 2002 through June 2022. In only four, including the last two, did we have a situation where rates are up as the PMI was declining and market returns were down (there were also only four since September 1998, but I excluded the earlier period because of its internet bubble and burst).
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“Safe” cheap, higher profitability, and low margin volatility companies perform well in this risk-off environment. Currently, low valuation stocks are outperforming, but during the other two periods in 2015 and 2018, high valuation stocks performed well. In all four, quality outperformed as characterized by high-EVA Margin, high ROC, and low EVA Margin variability. The reason that value is currently beating growth could be related to the third factor rotation macro driver – the spread of multiples between growth and value stocks. Later, I will show that the spread was quite stretched – growth was expensive – before this year’s bear market.
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The most common phases are ones in which rates, returns, and change in PMI are moving in the same direction. Figure 6 shows that all move up 30% of the time and down 22% of the time, and in these environments the sign on alpha for MVA Margin (and EVA Momentum, EVA Margin, and ROC) is opposite from EVA Margin Volatility (in Manage Risk by Managing Expectations, it’s shown that EVA Margin Volatility is positively related to beta). Markets that favor risk and low-value companies normally shun perceived safe high margin/high growth stocks, and vice versa.
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The worst period for growth stocks (-23.2% alpha for high-low MVA Margin) is when rates are rising when the PMI is accelerating and the market is up. That characterized 2021, and value (low-MVA Margin) stocks generated terrific returns. Let’s now look at each of the four factor rotation drivers in turn.
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Economic Growth and Interest Rates
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Over 22 years ago, in my first class as a professor, I was presenting on growth and value rotations and noted something to the tune that if the economy is strong then value tends to perform better than growth. In the same presentation, I showed how if monetary policy is restrictive then growth stocks perform well. A very wise PhD student (of economics) asked if those two statements were inconsistent. I expect he was one of the few students who read my entire over 2,000-page reading packet, which covered the investment process from the economy to asset allocation, style allocation, and sector allocation, to company analysis (business, financial, and valuation), and to performance evaluation and trading. Anyway, I gave his question some thought and during an early morning commute (commutes are good thinking time) the next day I came up with the answer. (Oh, and in case you are curious where that student ended up, we hired him. He is now chief analytics officer for BlackRock and a portfolio manager. Smart guy.)
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Figure 7 shows the answer I provided him, which is an initial (as I studied these rotations) decision tree that focuses on the economic growth variable or expectations of future economic growth. If the economy is strong, then the weakest companies perform best. These firms are those with low profitability, which are inexpensive or value stocks. (Equation 4 of box 2 shows that profitability is directly related to valuation.) Under these circumstances, investors breathe a sigh of relief after the prior period of economic turmoil that preceded the recovery and stop selling value stocks. Since the rising tide of the economy lifts all ships, those that were sinking have the most to appreciate. Why pay up for growth, when a cheap value stock’s earnings rise from nothing to positive with the economy? Cyclical companies may have higher growth than the highest growth stocks. Risk falls as profits rise, lack of financing for troubled firms becomes abundant, and multiples
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On the other hand, if the economy is strong and interest rates are rising, then investors may begin to fear the next recession. If so, they may rotate to quality growth companies. Afterall, in a recession growth is scarce so growth stocks’ higher valuations are worth their prices. Quality stocks (i.e., high ROC or high-EVA Margin stocks) also perform well if their high ROC/EVA Margin is related to competitive advantage or growth independent of the economy and is therefore stable.
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The decision tree starts with the economy and then considers interest rates and how they impact expectations of the next phase of the economy. In general, though, economic growth and interest rates move together so both have the same impact on the value and growth cycle. 2016 through 2020 is an example of deteriorating growth and falling rates, which provided a nearly perfect storm for value. Figures 8-9 show that the economy was weakening while rates were declining, and value (low MVA/sales) companies got clobbered versus growth (high MVA/sales) stocks. The opposite is true for quality (high-EVA Margin) stocks, which have nearly mirrored the relationship of value stock performance.
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There’s another reason that growth stocks perform well when the economy weakens and rates decline. Because of how growth compounds, high growth stocks have proportionately much more – versus value stocks – of their free cash flow in years further from today. See box 6. Growth stocks are long-duration stocks. If interest rates decline, just like long-duration bonds, the values of growth stocks rise more than low-valuation low-duration value stocks. Growth is “scarce” during these episodes of weak economic growth, and anything scarce becomes more valuable, but the worth of higher outyear free cash flow of growth stocks is literally compounded by the impact of lower interest rates.
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2020 was a great year for growth stocks. The economy retreated for the first half year of 2020 and interest rates declined throughout the year. Then came the vaccines and an economy that roared back to life in late 2020 through early 2022 and rates rose. Value stocks soared. Value is still performing well even though PMI is now declining (see latest data in figure 8). Why? Time to introduce the 3rd factor rotation driver.
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Value Discount
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The annual change in the PMI turned negative (from a strong reading) at the end of 2021. However, rates continued to rise. So, we have conflicting readings for the value and growth factor rotation. The rising rates also could lead to a recession (this judgement has become the consensus), which also favors growth. Nevertheless, rising rates and the impact on discount rates hurts growth stock valuations as more of their free cash flows are further in the future. This effect is magnified if growth valuations are very extended relative to value, as they are today and were even more so at the end of 2020 and 2021.
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As figures 11-14 show, the discount of value to growth has been higher only during the internet bubble. Unlike the internet bubble, however, when highflyers had little earnings (or low-EVA Margin or low ROC), their profitability has greatly improved. Equation 4 of box 2 shows that if profitability rises so should the valuation multiple. Figure 12 (top right) shows that the EVA Margin of value stocks relative to growth stocks deteriorated from 2004 to 2020, which helps explain why value multiples declined versus growth.
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When the relative EVA Margin of value (versus growth) stocks is high relative to the MVA Margin discount of value (versus growth) stocks, future returns of value relative to growth are high (figures 15 and 16). More simply, when the low valuation of value stocks is not justified by a similarly low EVA Margin, then value stocks outperform. Figure 15 shows this was the case for the last two years. Expectations implied in the valuation for value stocks were beaten down so low, while expectation for growth stocks became unreasonably high, that the market “snapped” and the rotation to value was robust (red return line in figure 15). You can see that the same occurred during the bursting of the internet bubble in 2000. Except for a brief period after the 2001 recession when value barely underperformed, value stocks continued to perform well in 2002-3 when this factor suggested that they were overpriced. At the time, the other three style rotation factors somewhat favored value: (1) the economy was coming out of a recession, which favors value, (2) interest rates fell in 2002 and then rose by the end of 2003, which favors value, and (3) a bottoming market that turned to positive returns were a tailwind.
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As figures 17 and 18 show, from about 2016 to about mid-2020 the economy started hot but ended cold. That is, the PMI went from high and rising to contraction territory (it was decelerating). This last phase of the upcycle through the downcycle favors high valuation and high-EVA Momentum stocks. These can be speculative stocks, but also those with high profitability. Essentially, these stocks were bid up too far and then underperformed as the economy recovered. There were also two big drops in market averages (grey line), which favor risk off.
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Market Returns
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Value tends to perform well during risk-on markets (figures 19 and 20). Almost by definition, these markets are when stocks are up, as equities are a risky investment with uncertain cash flows, ample volatility, potential for loss, etc. Value stocks tend to be firms with lower profitability, so you would expect them to perform best when returns are positive. Of course, an exception to this is in 2022, as value has been performing well in a down market. This can occur when egregious high valuations are placed on growth/speculative stocks at the end of bubbles. Plus, rising interest rates favored low duration value stocks this year.
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Summary
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In summary, the annual outperformance of value over growth that began in 2021 was fueled by (1) high market returns, (2) a large value spread, (3) a rapidly improving economy, and (4) rising interest rates. All factor rotation drivers favored value, which was quite a reversal from the last half decade leading up to this when (1) the economy was sluggish, (2) the value discount was growing, and (3) interest rates were declining.
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Today, the valuation discount has narrowed but is still there, market returns are negative, the economy may be heading into a recession, and interest rates are still rising. Two of the four factors favor value and two favor growth. The most important factor, though, is the economy, which is in the growth camp since it is weakening. Perhaps it’s time to consider quality, reasonably priced companies that have corrected with the market? They typically won’t rise as much if we avoid a recession, but they normally won’t fall as much if we go into one as well.
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Valuation is Driven by Profitability, Growth, and Risk
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I’ve referred to high-MVA Margin stocks as growth or quality stocks. Equation 4 of box 2 shows that, theoretically, MVA Margin equals the EVA Margin in year 1 discounted at the cost of capital less the growth rate. I’ve also shown that when cheap valuation stocks perform best, low profitability, low growth, and high-EVA Margin volatility stocks perform well, and vice versa, so these variables “must” go together. Figures 21-26 prove that investors believe in these relationships.
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The graphs in the left column show data for sectors and those in the right column show intra-sector sorts of (1s) low- to (5s) high-MVA Margin. Since MVA Margin is determined by the value investors price the stock and bonds of a company relative to invested capital (as a percentage of sales), it measures investors’ expectations. These graphs show that higher expectations (higher MVA Margin) is related to higher growth (EVA Momentum), higher profitability (EVA Margin), and lower risk (EVA Margin volatility). Notice that, in general, the relationships are tighter for the within-sector sorts (right column). This makes sense because stocks within sectors have similar growth, risk, and profitability profiles, so differences in these profiles are rewarded by investors with different valuations. For instance, in industrials, a high-EVA Momentum company will be more clearly (a tighter correlation) rewarded with a high-MVA Margin because it is more than likely that the company has similar profitability and risk profiles as the sector.
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Should investors pay up for past growth and current profitability, though? In Manage Risk by Managing Expectations and Drivers of Growth, I show that growth and profitability tend to reverse over time. Investors are often too optimistic about the future based on past corporate success. In Finding the Investment Gems, I showed that lower future growth reliance (as a percent of value) leads to higher returns.
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Notice how health care is a consistent outlier in figures 21-6. It appears that investors are very optimistic about these companies’ growth profiles and ability to improve profitability. The same can often be said for communication services. It turns out that they are too optimistic for both. Figure 27 shows the 36-month outperformance of low- versus high-MVA Margin stocks by sector. The alpha rewarded to buying low-expectations stocks is highest for health care and communication services.
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Considering valuation alone (what you pay) does not generate as much alpha as combining it with fundamentals (what one gets). The market cares about the fundamentals, as shown by the correlations between value, growth, risk, and margins in figure 29.
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Figure 30 compares the returns from sorting based on value alone versus a composite of MVA Margin (lower is better), ROC (higher is better), EVA Momentum (3-year) (higher is better), and EVA Margin volatility (lower is better). The long-short (1s-5s) of composite has better returns and risk-adjusted returns, with the long-short alpha slightly better for 12 months and the advantage growing with a 36-month horizon.
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See figures 31-36. Cumulative alpha (compounding 3-month alpha from each rebalancing period) from the composite ends with up 4.32X, slightly below the 4.90X for the valuation factor alone (top graphs). If the holding period is extended to 12-months and 36-months, however, then the composite outperforms the value factor (middle graphs). While turnover is higher for the composite (bottom graphs), this is to be expected. The composite takes advantage of mispricing that occurs when the current valuation, which measures future expectations, does not correctly reflect current fundamentals – and of course those fundamentals can change. Turnover is especially high after bubbles burst and around recessions. Finally, the composite, being made up of value, growth, risk, and profitability factors, outperforms more consistently. The composite has better hit rates for 12-month and 36-month time horizons (middle graphs). Considering quarterly returns, low-MVA Margin stocks outperform high in 72% of positive return (equal-weighted) markets versus only 41% of down markets, compared with the top quintile of the composite outperforming the worst in 61% of the up markets and 52% which are down.
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Figure 37 shows the top three securities in each sector based on the composite score.
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Copyrighted by ISS EVA and reprinted with permission by ISS EVA. PDF available here and webinar here.
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