In June, Applied Finance published an article that explored the role of intrinsic value in passive indexing where we studied various value-weighted approaches to form position sizes based on market value, book value and intrinsic value alternatives. Using out-of-sample intrinsic value estimates from October 1998 forward, we observe higher risk-adjusted returns for intrinsic value weighted portfolios compared to “value” proxies based on a firm’s most recent market price or most recent level of common stock. This highlights that the ongoing debate regarding passive vs. active investing is likely irrelevant as long as both perspectives tend to willfully ignore a comprehensive valuation discipline.
In this update, we not only expand our focus to a broad US market passive study using Russell 3000 constituents, but we set out to answer an interesting question: “What portfolio would you recommend somebody hold in this environment?”. While the answer to this question is certainly dependent on many individual preferences in risk-reward, we believe portfolio construction based on valuation and wealth creation principles not only offers strategic out-of-sample merit since the 1990s that investors should consider in any market environment, but also outsized tactical benefits today.
As a brief reminder, the efficient market hypothesis presumes that the passive market portfolio lies on the tangency point between the capital market line (CML) and the efficient frontier, which we have plotted on the chart below. It is then assumed that investors can only outperform this frontier when leverage is applied to achieve risk-return profiles along the capital market line between the risk-free asset and the market portfolio.
Intrinsic value-weighted indexing, however, has delivered higher returns with lower volatility than a market value proxy since 1998. Applied Finance’s two primary points of emphasis are intrinsic value and wealth creation; we can study an intrinsic value weighted portfolio that includes all Russell 3000 constituents, as well as a version that further excludes companies that dilute shareholders through investment not supported by internally-generated cash flows.
A dollar invested in the market cap weighted index in October 1998 returned $7.19 by the end of June 2021. This improves to $8.66 with intrinsic value weighting, and further improves to $11.45 when wealth destroying, dilutive firms are omitted. These higher returns are accompanied by lower standard deviations of monthly returns. (4.51% for market cap weighting vs. 4.48% for intrinsic value weighting and 4.14% for intrinsic value weighting that excludes dilutive stocks) As an additional “valuation vs. cheapness” theme, we also note that using common stock to form book value weighted portfolios leads to lower returns with higher volatility.
Equipped with this risk-adjusted return data, we can plot the risk-return profiles for each alternative value-weighted index alongside our previous chart of the capital market line. We observe a higher slope for the capital allocation line associated with the intrinsic value weighted portfolio; this is further enhanced as dilutive stocks are excluded from the “intrinsic value + stewardship” portfolio.
Based on this, a couple of observations are noteworthy. Market-cap weighted indices do not reflect the tangency point on the efficient frontier. In the context of the Russell 3000, cap-weighting lags intrinsic value weighting by 90 bps per year, implying that diversification with over-valued stocks is not as useful as is often assumed in modern portfolio theory. Even in the context of passive allocation, investors benefit from positing sizing based on intrinsic value characteristics further enhanced with stock selection based on wealth creation themes.
Intrinsic Value Characteristics of Value-Weighted Indices
The improved capital allocation line attributed to intrinsic value weighted portfolios provides evidence of the strategic benefit of incorporating intrinsic value and wealth creation principles into portfolio construction. We can also explore the tactical benefit of these themes in today’s market environment, which is likely attributable to the tremendous amount of price volatility and new information that has bombarded investors since the start of 2020.
Our first set of charts highlights the upside characteristics of intrinsic value weighted portfolios (in blue) vs. a market cap weighted alternative (grey) across time. As of the end of June 2021, valuation upside in the Russell 3000 was 31.8% when intrinsic value characteristics determine position sizes. This upside deteriorates to 0.0% when market cap characteristics determine position sizing, and these themes are similar within the Russell 1000 (31.7% for intrinsic value weight vs. 0.8% for market cap weight) and Russell 2000 (34.2% for intrinsic value weight vs -10.8% for market cap weight).In our second set of charts, we plot the valuation gap between intrinsic value weighted indices and their cap-weighted alternatives. This highlights that current valuation gap levels have not been observed since the early 2000s, and investors can drastically improve portfolio valuation characteristics by deviating from market cap weighted passive allocations with a valuation discipline.
As we reviewed in our July 2021 tactical valuation update, there are notable factor-based and wealth creation themes that investors can consider to further improve a portfolio’s intrinsic value characteristics through stock selection.