Too much of a good thing is, well, not so much of a good thing.
That's the lesson that "smart beta" investors are likely to learn the hard way, according to investment guru Rob Arnott – a pioneer of the smart-beta movement.
What exactly is "smart beta"? To understand the answer to that question, you first need to understand what is not smart beta. For decades, stock-market indexes – which represent a particular section of the overall stock market (or the market as a whole) – were constructed the same way: The greater a stock's market capitalization, the greater the weight it carried in the index.
In a perfectly rational investment world, this would make complete sense. If an index is to accurately represent a portion of the broader market, a $565-billion (U.S.) company such as Apple should carry more weight than a small firm with a market capitalization of $250-million. But investors are far from rational – think back to the tech bubble of the late 1990s. Stocks can become very overvalued or undervalued in comparison to their underlying businesses' value, driving their market caps up or down. A market-cap-weighted index thus owns more of overvalued stocks and less of undervalued stocks – just what you should do if you want to lose money over the long-term.
Smart investors such as Mr. Arnott offered a solution: fundamental or "smart beta" indexes, which weight companies using metrics that gauge the quality of a business and stock (profits, debt levels, volatility of share prices). The trick, of course, is that you need to use metrics that identify stocks that are likely to fare well. Some smart-beta practitioners such as Mr. Arnott have done that, using historical testing to find ways to add 2 per cent to 3 per cent a year to returns by changing the way stocks are weighted in an index.
But the rapidly rising popularity of smart beta strategies has created problems, Mr. Arnott says. In recent commentary on his company's website, he wrote that as more and more investors have jumped on the smart-beta bandwagon, many smart-beta indexes have become substantially overpriced. And there comes a price at which even the highest quality company (or index) is a bad investment. He said that many strategists and academics alike are failing to distinguish between smart-beta approaches that truly identify winning companies, and those that are rising simply because people are jumping on the bandwagon – and that means trouble ahead. "We think it's reasonably likely a smart-beta crash will be a consequence of the soaring popularity" of smart-beta approaches, Mr. Arnott wrote.
But while "quality" stocks are quite pricey, Mr. Arnott says value stocks – defined in this case is those trading at low prices compared to their book values – are in the cheapest decile in history. They tend to be lower on the quality scale, and with investors focusing so much on smart-beta quality metrics, they have slid to bargain levels.
To me, the bottom line is that good investment strategies don't focus solely on quality or solely on value. They focus on both. That's what history's best investors – people like Warren Buffett, Benjamin Graham and Peter Lynch – have done.
My Guru Strategies, which are based on the approaches of some of these great investors, thus use a blend of quality and value metrics in analyzing stocks. Here are three North American stocks that currently have both quality and value, making them worth your attention.
Westlake Chemical Corp. (WLK-NYSE): Mr. Graham was known as the "Father of Value Investing," and this $6-billion-market-cap firm, which makes petrochemicals, plastics and building products, gets high marks from the strategy I base on his writings. It has both quality (just $764-million in long-term debt vs. $1.7-billion in net current assets) and value (its price-earnings ratio – using three-year average earnings – is 9.5, and its price-to-book ratio is 1.8).
Cogeco Inc. (CGO-TSX): This diversified communications corporation ($900-million [Canadian] market cap) is a favourite of the model I base on the writings of fund guru Joel Greenblatt, which likes its quality (27 per cent return on capital) and value (11.9 per cent earnings yield).
PacWest Bancorp (PACW-Nasdaq): This bank, with a $4-billion (U.S.) market cap, operates primarily in California; it has a 22 per cent long-term earnings growth rate and 21 per cent equity-to-assets ratio, demonstrating ample quality, while its 12.5 P/E ratio and 1.0 P/B ratio indicate the stock is quite cheap. It earns high scores from my Lynch-based model.
Disclosure: I'm long WLK.
John Reese is CEO of Validea.com and Validea Capital, and portfolio manager for the National Bank Consensus funds. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock screen service.