Value and profitability are inextricably linked and, when they’re combined in a portfolio, institutional investors can garner a healthy premium, said Sunil Wahal, professor of finance at Arizona State University, during a session at the Canadian Investment Review’s 2022 Investment Innovation Conference.
He likened the investment approach to building a hockey team, noting the goal is to recruit big and fast players. For example, it would be short-sighted to have really big players on half the team with really fast players on the other half. Instead, it’s best to have players that are both big and fast, he added.
“That’s the key to understanding this sort of phenomena. You don’t want value stocks that you might think of as cheap stocks. You don’t want really profitable stocks because . . . you’re going to have to pay for them [and] . . . they’re going to be priced appropriately. What you really want are cheap and highly profitable stocks.”
This strategy goes back at least six or seven decades, said Wahal. “[It’s] important to understand what you’re looking for versus what you get to observe in the marketplace.”
One way to achieve both value and profitability is to invest in portfolios that target specific risk and return objectives, he said. Admittedly, not all investors can do that due to the need for market clearing, he noted, but some can target this as part of an overall asset allocation system and formula.
Thinking about the market as a whole is another strategy he suggested. “You still buy the entire grid, the whole market, but you can systematically tilt away from the red toward the green. The difference is . . . in tracking error and volatilities, etc., but it is a very feasible way to do this.”
If you think about the entire market portfolio and tilt away from the red (growth and low profitability, for instance) toward the green (value and high profitability), it becomes easier to implement environmental, social and governance considerations without losing much in expected returns, said Wahal, noting this is because the portfolio weights and construction schema that are built into this approach — either exclusions or under weights — don’t affect the distribution of value and profitability very much.
“If you invest in just a value portfolio, . . . it represents about 10 per cent of the aggregate market cap. [A] joint value and profitability portfolio gets you about 18 per cent of the aggregate market cap — the difference in returns between those two . . . is about 10 basis points a month. That’s a healthy premium. [Historically,] that’s between 1940 and 2019. Other periods [will show] variations in those numbers, but the idea is basically the same.”
The science behind this type of investing lies in the public domain, he said, referring to the accessibility of supportive historical data and how portfolios using this approach have delivered benefits. It just requires a deep understanding of the science and measurement, he noted, adding it’s also extremely important to consider efficiency in portfolio construction.
Measurement is critical as well, said Wahal, which is why standard book-to-market ratios are problematic and why he suggests investors avoid using something like free cash flow to measure profitability because it has built-in discretionary capital expenditures. “Remember, we can’t measure the future. But what’s in prices are expectations of the future. And so, if you use measures like [earnings before interest, taxes, depreciation and amortization], they don’t clean out a bunch of accounting-related issues. You don’t get the same sort of persistence in those things.”
The devil is in the details when it comes to enterprise value, he added. “Depending on how one measures profitability and book values, the variation that you can get in returns is absolutely enormous. And generally speaking, [what you want] from a portfolio construction perspective . . . are measures that are systematic across the universe. That, I think, becomes incredibly important.”