The long-term impact of sectors on value
Leading index manager MSCI conducted a study on the impact of sector allocation on value strategies. They took three separate hypothetical versions of a value strategy. The first portfolio (“sector independent”) holds “cheap” companies regardless of sector. The second (“sector-related”) holds companies that are cheap relative to their own sector. And the third (“sector-neutral”) holds companies that are cheap relative to their sector while preserving the sector weights of the broader market.
The sector-independent approach resulted in a large overweight in financials and energy. The surge in oil prices this year led to strong performance in the short term, but over the longer term, this approach underperformed in part due to its sector (and industry) composition. Concentration within sectors led to higher tracking error, higher drawdowns, and a higher share of lower quality “value traps.”
The second sectoral approach mitigated many of these effects but still resulted in significant sectoral skews. In contrast, we found that applying sector neutrality and relativity (as was done in the sector-neutral approach), derived the value premium without assuming the inordinate risks present in the other approaches.
Leaving the sectors unconstrained caused large deviations
Monthly average sector weights over the period December 2000 to May 2022:
As you can see, the financial and energy sectors are heavily overweighted in a sector-independent value strategy. Indeed, these sectors are full of these value stocks rightly for their lack of visibility most of the time as well as a low recurrence of results, as you can see in the chart below:
There are many “value traps” in these sectors, as companies in the energy and financial sectors are more likely to warn about their results and to disappoint in their publications.
These valuation errors lead to valuation and price readjustments, which are even more significant in the medium to long term. This results in lower linearity coefficients for the energy and financial sectors.
Hypothetical value strategies versus MSCI USA index
Annualized gross returns in USD from December 29, 2000, to May 31, 2022:
Thus, if we take “the best” value approach without looking at sectors, we underperform the benchmark with a higher risk. On the other hand, if we select the cheapest companies relative to their sector and keep the same sector allocation as the benchmark (MSCI USA), we outperform the index by 1% with equivalent risk.
In a few words,
If you have to remember one thing, don’t jump on the cheapest stocks just by looking at their P/E and without looking at what explains this valuation. Very often, entire businesses are undervalued, for a long time and for good reasons: whether it is because they offer less visibility, less recurrence of results, because the future prospects are less flourishing or because they are very capital intensive. There is often an explanation for this “cheap” appearance.