International | Sep 30 2021
Research by The Leuthold Group suggests better returns await those investors who combine cheaper asset prices ('Value') with a Quality assessment.
Q’Val: A Factor Powerhouse
By Scott Opsal, The Leuthold Group
Quant researchers widely agree that Value offers a return premium over time (although not recently) and that High Quality also offers excess returns.
The Quality angle seems contrary to intuition, in that investors generally prefer Quality companies and are willing to pay up for them, yet Quality regularly outperforms. Value and Quality are both well-respected investment factors, and we were curious to explore the interaction of these two smart beta stalwarts.
Is Value enhanced by adding a layer of Quality, thereby avoiding value traps, or are Value investors better off buying junky, unattractive companies that have the most room to rebound from depressed prices?
Our study measures the interaction of Value and Quality using a two-stage methodology. First, we quin-tile companies based on the Value factor and focus on the cheapest basket. Second, we divide the cheap-est Value basket into the 40% of companies with higher Quality ratings (Quality Value or Q’Val), and the 60% of companies with lower Quality ratings (Junky Value or J’Val).
The Quality and Value signals in this study are proprietary multi-factor models employed in our own portfolio management processes.
Quality-Enhanced Value
Again, our objective is to determine whether Value investors are better off tilting toward Quality companies, or if owning the junkiest companies offer the best bargain opportunities.
We begin with an analysis of the basic Value factor using the cap-weighted S&P 500 universe from 12/31/1996 through 8/31/2021. Chart 1 plots the return spread between the cheapest and most expensive S&P 500 quintiles, rebalanced monthly.
It paints the familiar story of Value’s outperformance up to the Global Financial Crisis, followed by a sideways decade and the recent drop caused by the outperformance of Social/Mobile/Cloud growth companies. While conventional Value signals that rely on price to book peaked in late 2006, multi-factor Value metrics based on other well-regarded ratios only succumbed to the mega-cap growth boom in 2017.
This study focuses on the “best value” sleeve comprised of the cheapest quintile of companies. Our next step is to separate the cheapest Value stocks into two Quality sleeves to determine which, if either, provides an extra boost to the Value factor’s excess returns over the long run.
Chart 2 begins with the best Value quintile’s 11.8% annualized return, then adds the returns for the Quality and Junky sleeves of the cheapest Value companies. On a long-short factor basis, Q’Val outperformed J’Val by 1.5% annually. Even on a long-only basis, it added another 0.4% on top of the return from the Value style itself.
The Cyclicality of Quality Value
One of Leuthold’s fundamental beliefs is that most indicators cycle over time, and that style and asset class leadership rotates based on economic and market conditions. Our next two charts delve into the cyclicality of Quality Value minus Junky Value by relating it first to the overall market and then to the Value cycle itself.
Chart 3 plots the Q’Val – J’Val spread over the last 12 months on the left axis, matched against the in-verted S&P 500 return on the right axis.
Other than the TMT bubble in the early section of the chart, the two series demonstrate an obvious correlation in directional shifts. Strong gains in the Q’Val metric are associated with periods of weaker market returns, whereas Q’Val lags J’Val when the market re-turn surges toward and beyond +20%.
Chart 4 repeats the Q’Val minus J’Val spread, this time compared to the broader Value cycle.
The red dashed line plots the T12 spread of the cheapest Value quintile minus the dearest quintile, inverted. When the red dashed line is lower in Chart 4, it indicates periods of strong returns to the overall value factor.
In this case, Q’Val tends to lag J’Val. When the red line is higher in the chart it means the Value factor is underperforming Growth, and Q’Val tends to perform much better in this scenario. We again find a strong directional correlation, this time between Q’Val and the relative style performance of the Value factor.
It seems clear that Quality Value has a definite cyclical flavor to its performance:
1. Q’Val outperforms during weaker market returns and underperforms when market returns are particularly strong, and
2. Q’Val outperforms when Growth is the dominant style theme but underperforms when the Value factor is dominating Growth.
This pattern takes us back to our original question; should Value investors prefer Quality or Junky? When the Value factor is “in gear” investors looking to maximize their tactical bet on a Value style rally should prefer J’Val.
Similarly, when the market is in rip-roaring bull mode, J’Val tends to give investors a bigger bang for their buck. However, the 1996 to 2021 period suggests that such occurrences are not frequent enough to give J’Val the edge over time.
Quality Value In Broader Indexes
The S&P 500 Universe has three biases that could potentially influence the results of our study.
First, companies must be profitable to be added to the Index, and we believe the S&P Index committee is biased toward companies of above-average quality. Second, the largest Index members are growth companies which gives this cap-weighted index a clear tilt toward that style. Third, the S&P is a large cap index, and it is quite possible that the factors we are studying behave differently in mid and small caps.
We examine the S&P’s quality growth bias by extending our research to the Leuthold 3000 universe. This brings in companies that are smaller, unprofitable, mature, and cyclical to give us a fuller picture of the Quality Value phenomenon.
Our Leuthold 3000 baskets include a) the largest 1000 companies by market cap, b) 800 midcap companies that rank below the largest 200, and c) small cap companies ranked below the top 1000.
Rather than charting each universe, we summarize the results in tabular form.
Table 1 reflects the Value factor across universes, indicating that the valuation effect becomes stronger as we work down the market cap spectrum. A curious aspect of Table 1 is that the majority of the Value effect in large caps is on the long side of the trade, while the biggest gains in mid and small caps come from being short the dearest companies; an important distinction for constructing portfolio strategies.
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Table 2 then divides the best Value quintile into Quality and Junky. The effectiveness of this combined measure also improves as we move down in market cap. We also note that all three of our Leuthold 3000 baskets contain unprofitable, lower-quality companies, and that the mid and small cap baskets have a much flatter distribution of company weights than does the S&P 500.
We believe each of these distinguishing characteristics contribute to the increased effectiveness of Quality Value in these broader universes.
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Remember, these two tables are additive in that the Q’Val premium comes on top of the Value factor premium. For example, in the largest 1000 companies, the Value factor outperforms the universe by 1.2% per year, and Q’Val outperforms the cheapest Value quintile by another 1.3% for a 2.5% combined advantage.
Similar data for the mid cap universe show a 1.1% Value factor edge and a 1.0% Q’Val gain for a 2.1% total. Small caps rack up a 3.7% advantage for Value and another 2.5% for Q’Val for a 6.2% combined win.
Investors able to short the least desirable baskets can realize even larger gains. Summing the long-short spreads for each table reveals a combined 3.8% gain for the S&P 500 and the Top 1000, 6.1% for mid-caps, and 12.6% for small caps.
We suspect one reason the Q’Val is so strong in small caps is that the percentage of unprofitable smaller companies hovers near 40%. While money-losers have speculative appeal during periods of extreme optimism, they have generally not represented a successful long-term strategy.
Finally, our examination of the cyclical charts for each universe (similar to Charts 3 and 4) confirms that Quality Value’s outperformance in weaker markets and growth-driven markets is consistent across each cohort of companies.
In fact, the fit appears tighter in the mid- and small cap universes, to the extent that we believe tactical calls could be implemented using this powerful combined quant factor. Charts for our Small Cap universe are shown in the Appendix; compare their patterns to the S&P 500 charts shown in the body of the report.
Research Takeaways
Value and Quality are cornerstones of the smart beta world, and together they create a powerhouse quant metric. Adding a Quality overlay to the Value factor produces enhanced returns across the market cap spectrum, with the greatest impact in smaller companies.
Quality Value, like most styles, is cyclical. Q’Val works best in weaker markets and in markets driven by growth leadership. Junky Value performs well in spirited bull markets and in periods when the Value factor is exceptionally strong.
Over the long run, Q’Val carries a meaningful advantage, and this combined factor can be utilized in either a strategic or tactical investment discipline. We are particularly intrigued by the possibilities for Value managers who are looking to avoid value traps or gain extra protection in bearish environments.
This research was re-published in full with permission.
Appendix
Technical limitations
If you are reading this story through a third party distribution channel and you cannot see charts and tables included, we apologise, but technical limitations are to blame.
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