Value is broken, but a new generation of ETFs could fix it

by , 2nd November 2018

[This is the third article in a series on breathing new life into value investing].

Many moons ago I wrote a long old book on stock screening – based in turn on a regular newsletter about stock screening run by the Investors Chronicle. Rather amusingly that book is now out of print and allegedly costs hundreds of pounds to buy second hand. Sadly, I have only a few copies left, otherwise, I’d be treating friends to a nice slap up dinner on the proceeds of selling those last few copies of the book.

This interest in stock screening sparked my lifelong interest in quantitative-based investing, by which I mean using systematic strategies to try and screen out behavioral bias. I found myself drawn to the ideas of Ben Graham and Joseph Piotroski and for decades I’ve regarded myself as fundamentally a value-focused, contrarian investor. I still can’t quite stop myself looking down the list of stocks hitting the 52 week low and thinking “are these a bargain”. The answer is probably not because the downside of all good contrarian strategies is that most of the ‘target’ stocks are genuine rubbish. And crucially, you only make a profit in this form of distressed investing if you are:

  1. Willing to be bloody patient and
  2. do it systematically, by ignoring your own cognitive biases.

Over time I’ve tended to stay away from stock picking – leaving the development of systematic stock strategies to the likes of Stockopedia, who do a great job. By contrast, I’ve taken those ideas and tried to apply them to the world of ETFs. Rather than using stock screening strategies to identify individual stocks, why not use the same ideas to identify big baskets of stocks? Thus, smart beta has merged into factor-based investing and ended up in ETFs.

But if I’m honest, when I look down the list of stocks in most ‘value’ ETFs I tend to feel a tad disappointed. Sure, by the quantitative measures used, these ‘value stocks are a bit cheaper than the main market, but they aren’t what I traditionally understood to be ‘value’ stocks.

Yet in truth true deep value investing is itself largely dead, except perhaps in Japan. Archetypal Ben Graham “Net-Net” stocks, for instance, are almost non-existent and what we’re left with are what I would call ‘anaemic’ value stocks i.e they are just a bit cheaper than the average.

I’d also argue that the sophistication of many quant driven value strategies used in ETF land is a tiny bit underwhelming. In reality, most strategies simply focus on the PE ratio, price to book and perhaps the dividend yield. The incredible sophistication of Piotroski like points scoring systems has been junked for simplicity.

But value investors also need to recognise that their traditional methodologies are increasingly redundant. The traditional focus has been on hard assets, yet we are midway through an epochal change in capitalism towards a system built on Intellectual property and brands. Thus, most traditional value investors ignore a huge part of the modern capitalist economy.

More “progressive” value investors such as Gary Channon at Phoenix have reacted by adopting their philosophy to one which is more quality in style terms but with a touch of growth at a reasonable price or GARP. This, in turn, reflects the shift in thinking of sage value types such as Buffett and Munger, who’ve had to change their stock selection strategies in order to buy real-world businesses.

So far, much of this evolution in thinking about value hasn’t found its way into mainstream value based smart beta – we’re still stuck in Value Indices Vs 1. But this year, in particular, we’ve seen a new type of ETF – such as the value ETF listed by the Chicago based firm Distillate Capital, interviewed by my colleague David Tuckwell – which I think could be the start of something much more interesting. If they deliver on their promise, it could be a more useful, modern version of value investing that might actually work.