The value style of equity investing has faced severe structural headwinds over the past decade. NN Investment Partners thinks that this secular underperformance is due to several factors: the unconventional tools used by central banks across the world, the technological disruption that traditional value sectors face, and the low level of interest rates and absence of inflationary pressures. “Even in the face of these headwinds, value-based portfolios can still beat the market by adapting to the changing world around us”, said the asset manager in a recent publication.
In their view, equity managers with a value style have been left with few tools with which to navigate the turbulence of the past decade. Some have opted to stick with the traditional approach that succeeded prior to 2007 based on a buy-and-hold philosophy. “More often than not this implied waiting for mean-reversion, while facing the risk of holding so-called value traps; that is, companies that are cheap for good reason and that will continue to underperform the market, owing to either a broken business model or poor management”.
Others have integrated new tools in the investment process that reduce drawdowns, while maintaining “true to style” portfolios with key value characteristics. This is the option chosen by NN IP for managing the Euro High Dividend and European High Dividend strategies, and “the results speak for themselves”. Over time, these funds have outperformed on a relative basis, even with the significant headwinds facing the value investing style.
The asset manager points out that this “demonstrates that by taking an adaptable approach, value strategy investors can still beat the market”. To achieve this outperformance against peers and the broader market, they have integrated three key pillars of adaptability into their process.
1. Adapting to their own biases
Every portfolio manager has behavioral biases, which is not an issue as long as they are aware of them and compensate accordingly. By analyzing more than 10 years of portfolio trading history, the firm identified the behavioral biases that negatively affected performance as well as those areas where they work in their favor. “For example, the process of rebalancing our allocations back to target weights has been a substantial source of positive alpha over time. On the other hand, sticking with underperformers and being overly loss-averse was a source of negative alpha”.
Having become aware of these biases, they systematically reviewed the list of potential value traps in their holdings, then acted to cut them. This created significant positive alpha during the period of market volatility caused by the COVID-19 crisis.
2. Managing unintended macro risk
“All portfolio managers know the absolute level of risk in their portfolio. Some, however, aren’t aware of how underlying elements contribute to this risk and thus fail to actively manage it”. By analyzing the sources of risk, avoiding potentially unintended macroeconomic risks and allocating the majority of their risk budget to the idiosyncratic (stock-specific) component, the asset manager significantly reduced their portfolios’ sensitivity to unexpected external shocks.
As they pointed out, this approach did not prevent the strategies from remaining “true to style” as they retained their positive exposures to the value and dividend factors, but in a way that controlled macro risk.
3. Using ESG factors to enhance risk-return ratios
Value portfolio managers can screen their investable universe to seek out the most attractively valued names. However, simply conducting basic valuation screens heightens the risk of owning value traps. NN IP thinks that, as well as screening on valuation, portfolio managers must conduct an in-depth qualitative assessment of each company. “We have found that by consistently integrating ESG factors into our investment process and actively reducing exposure to companies with high levels of ESG risk, we can offer a better risk/return ratio than most of our value/dividend peers”.
Their norms-based approach for exclusion, engagement and voting, combined with the qualitative assessment of a company’s relevant ESG risks and their potential financial impact, reduces drawdown risk for their European and Eurozone dividend strategies. Monitoring ESG risks at portfolio level (using a proprietary Corporate ESG Indicator) provides another layer of risk management that limits unintended ESG risks.
“These three pillars have a common thread: by embracing the changes offered by the investment environment, value portfolio managers can strengthen their risk-adjusted returns while staying true to style”, stated the firm. Instead of sticking with the Value 1.0 approach that worked very well prior to the Great Financial Crisis, but has exhibited very poor risk-adjusted returns since then, NN IP has adapted their processes to this new reality. In doing so, they have delivered significantly better risk-adjusted returns than most of our value/dividend peers. “Value 1.0 is dead; long live Value 2.0”, they concluded.
For Funds Society, Madrid