When it comes to explaining value stocks and funds to clients, advisors don't have to stretch because the strategy is straight-forward and many clients are already familiar with it.
Put simply, traditional value investing centers around identifying securities that trade at discounts relative to fundamentals, such as price-to-book, price-to-earnings, cash flow or dividends, among others. Doing that on one's own can be burdensome, hence many advisors (and their clients) prefer funds – active and passive – for value exposure.
Simple enough, but for clients that want to explore value on a deeper level, there's well, deep value. In the seminal 2017 paper aptly titled “Deep Value,” Cliff Aseness and the AQR Capital Management team explore the concept of deep value.
“We define 'deep value' as episodes where the valuation spread between cheap and expensive securities is wide relative to its history. Examining deep value across global individual equities, equity index futures, currencies, and global bonds provides new evidence on competing theories for the value premium,” according to the paper.
Going Deep for Upside
Aseness and team point out some interesting results of the aforementioned scenario.
Those include the following: High average returns, low average betas but high betas relative to global value, weakening fundamentals, poor news flow, selling pressure, confinements to arbitrage activity and rising arbitrage activity.
Even with the appearances of those traits, “deep value episodes tend to cluster and a deep value trading strategy generates excess returns not explained by traditional risk factors,” according to AQR.
Of course, like many factor applications and seemingly everything else in equity markets, large caps steal most of the value and deep value despite the fact that the factor's track record with small caps is one of the most potent in the investment universe.
A foundation for advisors seeing the merits of deep value applied to micro- and small-cap equities is the DEEP Index (“DEEPi”), created by Tobias Carlisle.
DEEPi “seeks to identify deeply undervalued small- and micro-cap companies listed in the United States. Tobias Carlisle’s firm Acquirers Funds® manages the DEEPi index,” he writes. “DEEPi seeks to hold stocks with strong balance sheets and durable businesses run by shareholder friendly managers. We believe these businesses can deliver sufficient returns over time for the risks taken.”
Solid Way to Consider Small Caps
As advisors well know, clients often like domestic small caps due to the growth prospects offered by the asset class. However, advisors also know (and they should impart upon clients) that in markets and in life, there's no such thing as a free lunch. Meaning the trade off for rapid rates of top line growth can be lack of and long runways to profitability, among other dubious financial traits.
DEEPi has avenues for affording financially precarious small companies. Leveraging the Acquirers Multiple, the index considers factors such as buybacks, business durability, earnings quality and overall balance sheet strength.
“DEEPi examines the cheapest stocks ranked on the Acquirers Multiple® to ascertain whether or not accounting earnings convert into cash flow over time. DEEPi excludes stocks with accounting earnings that do not match cash flows over time,” notes Carlisle. “DEEPi looks at the balance sheet of each stock to determine whether it is conservatively financed—favoring net cash over net debt—and appropriate to the business. DEEPi excludes stocks with too much debt relative to the operating income.”
Putting a bow on the conversation, deep value isn't an opaque concept, but it's one many clients are likely missing out. Using DEEPi as the benchmark, advisors can reduce some of the risks and lack of quality associated with traditional small-cap strategies and that could benefit client outcomes over the long-term.
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