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TMX Group Inc. signage and stock prices are displayed on a screen in the broadcast center of the Toronto Stock Exchange (TSX) in Toronto.Norm Betts/Bloomberg

Academic studies have shown that, on average since 1980, value stocks have beaten growth stocks by about 10 per cent in Canada and, depending on the market, by between 6 per cent and 10 per cent in the U.S. The figures are smaller since 1998, but still significantly positive.

But this evidence does not square with the differences in returns between U.S. and Canadian value and growth exchange-traded funds. For example, XCV-T, the iShares Canadian Value ETF, has had an average annual return of 5.7 per cent, while XCG-T, the iShares Canadian Growth ETF, has had an average annual return of 6.5 per cent, since inception in 2006.

In the United States, the corresponding returns for IUSV-N, the iShares Core U.S. Value ETF, and IUSG-N, the iShares Core U.S. Growth ETF, are 6.5 per cent and 9.2 per cent, over the same period. The growth ETFs have actually performed better. What is going on? Does value investing work or not? It all depends on how one defines value and growth investing.

Investors widely use the terms value stocks and growth stocks, but many don't know what they mean. Academic researchers sort stocks by price-to-earnings (P/E) or price-to-book (P/B) or other valuation metrics, and form a number of portfolios from the sorted stocks. They call the lowest P/E stocks "value stocks" and the highest P/E stocks "growth stocks." While academicians don't know which stocks from the value group value investors will buy, they know that they choose stocks from the lowest P/E group and avoid stocks from the highest P/E group. ETFs only roughly adhere to this rule.

But value investing is more than that. Sorting by P/E, or examining other metrics, is just the first step in the value-investing process. Next, investors value each of the lowest P/E stocks to find their intrinsic value. Finally, they compare the intrinsic value of each stock with the market price. If the stock price is less than the intrinsic value by at least a margin of safety (normally around 33 per cent of the intrinsic value), the stock is considered truly undervalued and it's worth investing in.

Value ETFs do not meet the value requirements for either value investors or academics. They do not have a P/E, say, of less than 14-times, a price-to-book of less than 1.3-times and market cap of less than $400-million in Canada and less than $1-billion (U.S.) in the United States.

For example, for XCV only 21.8 per cent of its stocks have a P/E less than 14-times. For IUSV, it's 14.5 per cent. The median P/B is 1.6-times for XCV and 1.8-times for IUSV, while the median market cap is $8-billion (Canadian) for XCV and $1.4-billion (U.S.) for IUSV. These figures are way off the academic metrics or other metrics many value investors would feel comfortable with.

Why is this important?

Value investors start by identifying possibly undervalued stocks. This involves looking for stocks that are neglected or undesirable due to bad performance. Neglected are stocks that are small cap, have few analysts covering them and low liquidity. Undesirable are stocks with low P/E ratio or low P/B ratio.

Low liquidity or small-cap stocks are normally avoided by institutional investors. Smaller-cap or low-liquidity companies also tend to be followed by fewer analysts, and be less in the public eye than larger companies. Because of that, the stock of such companies is more likely to be undervalued.

The P/E and P/B multiples, on the other hand, are a function of the growth rate of earnings going forward. This relationship can be found in a mathematical formula derived from the equity-valuation model taught at every university. Companies have low (high) multiples because markets expect low (high) earnings growth. However, the way the growth rate comes into the mathematical formula implies growth forever. That is, a high multiple firm is forecast to sustain a high growth rate forever; vice versa for low multiple firms. The markets tend to be overoptimistic about growth for high multiple firms and overpessimistic about growth for low multiple firms. As a result, investors overvalue high multiple firms and undervalue low multiple firms.

Value investing is all about finding undervalued stocks, and these tend to be stocks that are smaller, and with fewer analysts following them, and low P/E and P/B. But this is not how ETFs are structured as they need stocks that are larger and have more liquidity, but these tend not to be truly undervalued stocks. And the results bear this out.

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