30 January 2020
In their second article exploring the themes helping them navigate European equity markets in 2020 and beyond, GAM Investments’ Niall Gallagher and Christopher Sellers examine the importance of the volatility theme in a market increasingly dominated by factor investing and question the stability of the low volatility paradigm which has been predominant for much of the last decade.
How value fares when volatility is suppressed
Factor investing has grown enormously over the past decade (as has risk management to factor risks) and factor shifts now play a significant role in market movements, as well as the gyrations beneath its surface. Growth and value styles are just two examples of the wide range of commonly used factors that are relevant from an investment perspective.
In our previous article on European equities, we discussed the wide valuation gap that has appeared to open between ‘growth’ and ‘value’ stocks. Here, we question whether this gap is just about the growth and value factors. Are other factors, such as ‘momentum’, ‘capitalisation’ and ‘volatility’ (price and earnings), and multi-factors, such as ‘quality’, also influencing the picture?
More specifically, we aim to explore the question of whether valuation anomalies within and between other factors are being obscured by the growth versus value debate, when really it is other factors that are increasingly out of kilter from a valuation perspective.
There are potentially an infinite number of common factors used to describe stock returns, but the most popular are grouped into ‘industry’ factors, ‘country’ factors and ‘style’ factors. The key style factors are: ‘momentum’, ‘capitalisation’, ‘volatility’, ‘growth’ and ‘value’. And many of these style factors are broken down into further sub-factors, or even combinations of factors, with the ‘quality’ factor being a good example of a multi-factor that combines growth, low price volatility and high return on equity.
Chart 1 shows the valuation relative to history of a range of factor baskets within European equities, while Chart 2 shows how these factors have performed over the last 10 years. The results are startling. Factors such as low price volatility and quality are very highly valued versus history, while the value factor looks very cheap versus history.
Chart 1: Valuation of various factors versus history
This also is reflected in how these factors have performed, with quality performing almost twice as well as the market. Growth and low price volatility individually also have performed much better than value and the market as a whole.
Chart 3 shows the correlation of various factors to the momentum factor. This illustrates that there is currently a very close correlation between momentum, quality and low price volatility, suggesting that quality and / or low price volatility ARE ‘momentum. Momentum’s correlation with growth also is high, but not quite as high, while it is currently very negatively correlated with the value factor. High positive correlation with the momentum factor is often used as a proxy for ‘crowdedness’, which itself is often associated with excessive valuation. The reverse is true for negative correlation with momentum. This may suggest that much active capital is crowded into low volatility and growth parts of the market, while value and high volatility are under-owned. This is corroborated by factor performance with (high) volatility a consistent underperformer over the last decade.
Chart 2: Performance of MSCI style indices
Chart 3: Factor correlations
Are low volatility stocks growth stocks and high volatility stocks value stocks?
Low price volatility is often considered to be a characteristic of growth stocks – with low volatility growth sometimes labelled defensive growth. So if low volatility as a factor is expensive, this supports the idea that growth stocks are expensive. Value indices and value factor baskets generally contain more cyclical stocks than their growth counterparts; the flipside of the extensive re-rating of low volatility stocks is the de-rating of higher volatility, or more cyclical, stocks.
However, growth and low price volatility do not overlap completely – and neither do value and cyclicality / high volatility. Individual stocks can exhibit numerous different factor characteristics. For example, several traditional value stocks in the insurance, utilities and telecoms sectors are included in low price volatility indices, perhaps due to their economic defensiveness. Chart 4 shows the top 15 stocks of the iShares MSCI Europe Minimum Volatility ETF, illustrating that a number of the top stocks in the index are from sectors of the market that would traditionally be considered value.
Chart 4: Top 15 stocks in iShares MSCI Europe Minimum Volatility ETF
The valuations of some of these traditional value, but low volatility, stocks are not particularly cheap versus history or relative to the market. Furthermore, when we examine a selection of cyclical growth stocks, we find that such stocks are not expensive versus history despite their growth status.
This raises some important questions:
Is there a valuation misalignment along the value / growth axis, with growth stocks expensive and value stocks cheap? Or is there a misalignment along the volatility axis, with low price volatility stocks expensive and high price volatility stocks cheap?
As low volatility stocks are often defensive, and high volatility stocks are often cyclical, are these misalignments a function of nervousness over the state of the global economy?
Our view, driven in most instances by our bottom-up analysis, is that volatility as a factor, or perhaps volatility in combination with value and growth, is a more convincing explanation of the increasingly extreme valuation dispersion in the European equity market than value and growth as factors alone. This stems from our belief that low / negative interest rates and large asset purchases by central banks (in the form of quantitative easing (QE)), as well as sustained – and inherently interlinked - nervousness over the state of the global economy throughout this cycle (the ‘wall of worry’) have suppressed volatility across multiple markets and led to a re-rating of low volatility securities.
It is widely claimed that long duration growth, or defensive, stocks, have re-rated as ultra-low bond yields have raised the discounted value of cash flows. We find such claims unconvincing. If the equity market were genuinely discounting current levels of ‘risk free’ rates as part of some Capital Asset Pricing Model (CAPM) paradigm, then all equities (not just some of them) would be much more highly valued than they are at present.
Instead, it is low volatility equities that have been re-rated the most, which we attribute to the volatility suppression that has occurred in the QE-dominant era.
In our next article ‘Value versus value traps’, we will consider how the broader macroeconomic backdrop and key secular themes are impacting on a range of traditional value (and growth) sectors, In particular, we will examine whether technological disruption and decarbonisation might render some value stocks which appear cheap as ‘value traps’.
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator for the current or future development. Reference to a security is not a recommendation to buy or sell that security.