Research Affiliates: When Value Goes Global

March 12, 2018

Key Points

  • The value premium is traditionally associated with stock selection and market timing, however, value investing works just as well when applied globally across major asset classes. 
  • The alternative value portfolios we study are typically uncorrelated with their underlying asset classes, traditional value approaches, and each other, thereby offering meaningful diversification benefits alongside attractive excess return potential.
  • The success of value portfolios hinges on their design, which allows investors to gain better exposure to desired risk premia not easily available when investing in a single market.

 

“Buy cheap and sell dear.”

— Benjamin Graham, The Intelligent Investor

 

Value investing, a well-known and popular strategy, enjoys broad adoption in the investment community and is supported by a wide array of academic articles. Investors likely associate the word “value” with terms such as book-to-market ratio, price-to-earnings ratio, and bond yield, which are traditionally used for selecting investments in individual stocks, an entire equity market, or local government bonds. A robust body of literature, however, indicates that value strategies work just as well when investing globally across international equity indices, foreign government bonds, currencies, and commodities.1

Global value portfolios are indeed attractive. As we review in this article, these strategies offer notable risk-adjusted returns, which are largely uncorrelated with the underlying markets. Moreover, they have succeeded when traditional value approaches have fallen short. For instance, using valuations to invest across global equity markets and international government bonds has proven to be a worthwhile endeavor. In contrast, equity valuations and bond yields have been of little help in predicting mean reversion within US stock and bond markets (e.g., Masturzo, 2017, and Garg and Mazzoleni, 2017).

With significant potential to enhance an investor’s portfolio, a natural question arises: What makes these global value strategies so effective? To fully harvest value premia in global markets, the use of derivatives and shorting may be necessary. Derivative contracts, however, are merely an instrument and alone do not provide sufficient conditions for success. The success of value portfolios hinges on their design, which allows investors to gain better exposure to desired risk premia not easily available when investing in a single market.

We highlight three explanations for the success of global value strategies. First, long–short portfolios allow investors to hedge movements in the markets that may not be simple to time when investing in a single asset. For instance, equity price-to-earnings ratios have been steadily rising over recent decades, compromising their ability to successfully forecast equity markets. Second, global portfolios are well suited to identify and capture alternative sources of value premia, all while controlling for other factors that may not be desired in the portfolio. Indeed, we document that a traditional approach to timing US Treasury bonds may actually have little to do with the value phenomenon. Lastly, diversification is said to be the only free lunch in finance, and this idea applies to the value factor as well. For example, predicting the path of the US dollar against a basket of other major currencies—a single concentrated bet—is more challenging than forecasting the relative path of multiple currencies in a broad basket of currencies—a diversified set of multiple bets.

In sum, value is a robust phenomenon that can take several different forms and its success on a global stage depends on an economically motivated design. Indeed, as emphasized by Israel, Jiang, and Ross (2017), a number of seemingly small decisions can significantly influence subsequent portfolio performance.

Value In Equities: From Traditional Approaches To Global Portfolios
Today’s possibly best-known application of value investing is in the selection of individual stocks. A value strategy selects securities that trade at a discount, or at a price below intrinsic value, a recommendation that goes back at least to Graham and Dodd (1934). In practical terms, investors should seek companies whose stocks are trading at low prices relative to their earnings and book values. This practitioner advice was later validated in the academic community with the pioneering work of Fama and French (1992), whose high-minus-low (HML) factor has since shaped the academic literature on empirical asset pricing.

Valuation metrics can also be used to time an entire equity market. The literature offers a set of relevant metrics to estimate the market’s fair value, an admittedly challenging exercise. In particular, following the work of Campbell and Shiller (1988), the cyclically adjusted price-to-earnings (CAPE) ratio has become a popular indicator of value (e.g., Arnott, Kalesnik, and Masturzo, 2018). The CAPE ratio compares the current market price to the average of the previous 10 years of earnings expressed in today’s dollars, thereby eliminating seasonal fluctuations and smoothing economic cycles. Arnott, Kalesnik, and Masturzo explored this topic in great detail.

 

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