Stock Market: How to Shift to Value Investing in an Overheated Market
As analysts call for a rotation into value investing, financial expert Gordon Pape takes a look at how we can adjust to the market trend. Photo: g-stockstudio/Getty Images
Many analysts say we are experiencing a rotation into value investing. But what exactly does that mean?
According to Investopedia, a value stock trades at levels that are perceived to be below its fundamental worth. Common characteristics of value stocks include a high dividend yield and low price to earnings and price to book ratios. In short, value stocks theoretically trade at bargain prices.
A true value investor tries to find stocks that the market has overlooked and are trading below their intrinsic value.
The problem is there are not many stocks that are seen as true “bargains” in today’s overheated markets. Value stocks don’t have the sky-high p/e ratios that have hit the tech sector recently, but they aren’t cheap by historical standards.
This poses a challenge for investors trying to follow the current market trend. A close look at three ETFs that focus on Canadian value stocks exemplifies the problem.
The iShares Canadian Value Index ETF (TSX: XCV) seeks to deliver long-term growth by replicating the performance of the Dow Jones Canada Select Value Index, net of expenses. Blackrock Canada says the fund provides exposure to large- and mid-cap companies that are “thought to be undervalued by the market relative to comparable companies”.
But what are these undervalued companies? Basically, banks and insurers. The top five positions in this fund are the Big Five Canadian banks. Together, they account for 43.5 per cent of the ETF’s holdings. Overall, financials make up almost 65 per cent of its total assets. Materials are a distant second at just under 14 per cent.
That mix has worked well in 2021, with the fund up 15.45 per cent year-to-date as of March 11. But you would have done even better with a pure financials fund. The iShares Equal Weight Banc & Lifeco ETF (TSX: CEW) is up 16.2 per cent in the same period.
There’s more to the world of value investing than financials. Consider the BMO MSCI Canada Value Index ETF (TSX: ZVC). It’s based on the the performance of the MSCI Canada Enhanced Value Capped Index, net of expenses. The ETF invests in Canadian companies that have higher value characteristics based on price-to-book value, price-to-forward earnings, and enterprise value-to-cash flow from operations.
What that means is that this is a much more diversified fund. It too holds the top banks and insurers, but they only represent 36 per cent of the total assets, compared to 65 per cent for the iShares fund. The BMO entry also has substantial positions in energy, materials, industrials, and information technology. The largest holding is CN Rail, which doesn’t even make the top 10 in the iShares fund.
If you want a value fund that ignores the big banks entirely, check out the CI First Asset Morningstar Canada Value Index ETF (TSX: FXM). It holds 30 securities, most of which fit the classic definition of undervalued.
This is a very well-balanced portfolio, with 17.8 per cent in utilities, 17.1 per cent in financials (mainly insurers), 13.1 per cent in industrials, 11.9 per cent in materials, and 10.9 per cent in energy. Top names include Ovintiv Inc. (formerly Encana), Bausch Health, Equitable Group, Seven Generations Energy, Corus Entertainment, and Cascades Inc.
Performance has been impressive. The one-year gain to the end of February was 31.7 per cent. The five-year average annual compound rate of return was 10.1 per cent. The management fee is higher than the iShares or BMO funds at 0.6 per cent, but the results are worth the extra cost.
For geographic diversification in your value ETFs, consider adding one or two that invest in U.S. and international stock markets.
For the U.S. market, Blackrock Canada offers the iShares MSCI USA Value Factor Index ETF (TSX: XVLU). It was launched in September 2019, so it doesn’t have much of a track record. However, it’s really just a clone of a U.S. fund of the same name that trades in New York under the symbol VLUE.
VLUE has been around since 2013 and posted an average annual return of 13.6 per cent over the five years to Feb. 28. The one-year gain was 26.7 per cent, with all of that coming in the past two months.
Somewhat surprisingly, given it’s a value fund, information technology is the largest category, with 29 per cent of the assets. Key holdings include Intel, IBM, Cisco Systems, Applied Materials, and Micron Technology. There is also significant exposure to consumer discretionary, health care, communications, and financials. The MER is very reasonable at 0.15 per cent. The Canadian equivalent has an MER of 0.31 per cent.
Another option is the BMO MSCI USA Value Index ETF (TSX: ZVU). Its portfolio is very similar to that of the iShares entry but its performance over one and three years is not as good.
An international entry to consider is the Vanguard Global Value Factor ETF (TSX: VVL). It’s an actively managed fund that uses a proprietary model and includes large-, mid-, and small-cap stocks from developed markets around the world.
The portfolio is heavily concentrated in the U.S. (about 64 per cent of total assets), with other significant positions in Japan (8.2 per cent), Great Britain (4.9 per cent), and South Korea (3.8 per cent). Canada accounts for 2.6 per cent of the portfolio.
Financials top the list at 26 per cent of assets, followed by consumer discretionary (14.6 per cent), and industrials (14.5 per cent). Top holdings include Volkswagen, Micron Technology, Intel, Citigroup, and Morgan Stanley.
Performance has been uneven since the fund was launched in 2016, with gains in 2017 and 2019 and losses in 2018 and 2020. But right now, this ETF is doing well with a year-to-date gain of 10.4 per cent.
As you can see by looking at these funds, value is very much in the eye of the beholder right now. Of this group, my first choice would be the CI First Asset Morningstar Canada Value Index ETF. It closed Friday at $18.66.
If you want to pair it with a non-Canadian fund, I’d opt for the iShares U.S. entry that trades in New York as VLUE.
Gordon Pape is Editor and Publisher of the Internet Wealth Builder and Income Investor newsletters. For more information and details on how to subscribe, go to www.buildingwealth.ca.