This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by Scott Kubie, chief strategist of Omaha, Nebraska-based CLS Investments.
Deep value looks attractive, and Guggenheim’s S&P 500 Pure Value (RPV | A-61) is a top pick in the space.
The positive outlook toward deep value can be broken down into two recommendations. First, value stocks are poised to end the long period of growth outperforming value. Second, within value, deep value stocks rank as the most attractive.
Pure value, as suggested by its name, creates a more intense exposure to value stocks. In contrast to the S&P 500 Value, pure value includes just one-third of the market capitalization. The S&P 500 Value includes half the capitalization and includes some stocks that are also included in the S&P 500 Growth. Pure indexes eliminate the positions that are a mixture of growth and value characteristics.
Once the universe is pared down, the portfolio is weighted based on the value characteristics of the stocks, rather than the market capitalization. For example, HP Inc.—the computer and printer portion of the old Hewlett Packard—is only 0.24% of the S&P 500 Value. It is the second-largest holding in RPV, at 2.41%.
In the era of the smart-beta ETF, the talk about which factors add value over the long run includes a relatively narrow list. Value is almost always on the list. Yet over the last 10 years, value has lagged growth considerably. While pure value has done better than traditional value, it too is behind. Over the last two years, RPV has lagged significantly. Given the gap, value bouncing back is likely.
One reason to expect a bounce back is that pure value is cheaper than normal. Because the index includes stocks with low valuations, that is normally the case. Yet the current gap between pure value and other indexes is wider than normal. The table below shows how attractive RPV has become relative to other indexes.
Source: Morningstar Direct; includes only periods with a positive P/E ratio
The average 10-year price-to-earnings ratio shows that value stocks are generally cheaper than growth stocks. I included the iShares Morningstar Large-Cap Value (JKF | A-91), because it has similar holdings to RPV, but weights its holdings based on capitalization. The current P/E shows the values at the end of March. While most of the ETFs have seen an increase in valuations, RPV is slightly cheaper on an absolute basis.
The next two columns calculate the difference between the P/E ratio for RPV and the other ETFs. The first column shows RPV is normally in line with Morningstar Large Value, somewhat cheaper than S&P 500 Value, and much cheaper than S&P 500 Growth. The final column shows current values. The gaps are all much larger than normal and reflect that RPV is significantly cheaper than usual. I expect the gap to narrow.
If inflation picks up or interest-rate increases are faster than investor expectations, pure value stocks are positioned to benefit. RPV’s allocation to the combination of materials and energy is 7.5% above the S&P 500’s allocation to these same sectors. Financials, which would likely benefit from rate hikes, receive more than 25% of RPV’s allocation compared with 16% for the S&P 500.
RPV shows high levels of volatility relative to the index. Over the last 10 years, RPV has been over 50% more volatile than an S&P 500 ETF, and just under 50% less volatile than the S&P 500 Value. The long-term beta is 1.40, suggesting that most of the excess risk is systematic and not easily diversified.
These high risk scores have moderated significantly in recent years. During the financial crisis, deep value companies (especially financials) faced uncertain futures. In 2008, RPV dropped 48%, trailing the S&P 500 by 11%. Conversely, in 2009, RPV rose 54%, compared with the S&P 500 rising 26%.
RPV can also outperform in years where value lags, or vice versa. During RPV’s stunning performance in 2009, the S&P 500 Value lagged the S&P 500 by 5%. Keep the potential for volatility in mind if you included this positon in your portfolio.
Word Of Caution
The holdings look terrible. Don’t look at them! Keeping the perspective that you own a collection of companies unloved by investors, which have historically bounced back, may allow for future outperformance. Looking at the holdings will remind you that you don’t love these companies either.
At the time of this writing, CLS Investments invests in RPV, IVW and IVE for its clients. CLS Investments is a third-party investment manager and ETF strategist. It began to emphasize ETFs in individual investor portfolios in 2002, and is now one of the largest active money managers using exchange-traded funds. Contact CLS’ Chief Strategist Scott Kubie at 402-896-7406 or at firstname.lastname@example.org. Please click here for a complete list of relevant disclosures and definitions.