Morningstar - Q3 2020 - 61

investors who hold a concentrated portfolio
might know a lot more about one individual
company. We replicate that process across
thousands of companies, and that diversification
helps. We may not be sure about a particular
name, but we do know that on average, buying
cheap securities relative to fundamentals
can generate positive returns. We take a bet that
prices will revert toward the fundamentals.
We might do it across thousands of names.
Fundamental investors might do it across a few
names. But the process is similar in spirit.
Ang: There is a role for both systematic or factor
investments as well as more discretionary or
fundamental investments in a portfolio. They hit at
different things. We believe in indexes plus factors
plus alpha. Market-cap indexes are standard
benchmarks for good reason: They're transparent
and they can be implemented at extremely
low cost. Factors, where Andrea and I live, are
broad and persistently rewarded sources of returns
in the long run, but there can be some shortterm cyclicality. The tremendous value losses over
the past two to three years is testament
that these effects have been very broad in the
wrong direction!

For the last component, alpha, what we really
mean is returns in excess of what you can get from
indexing and factors. A fundamental investor
can concentrate on just a handful of names in a
given sector or country and know everything about
them-the analyst might walk a factory floor
or be able to interpret emotion on an earnings call.
That's very specialized knowledge. Or you could
generate alpha by sophisticated machine-learning
techniques that require massive amounts
of data or infrastructure and specialized skills.
There's room for indexing and factors and
alpha, and we need all three more than ever
in today's environment.
Bryan: Thank you both. Value investing is front

and center for a lot of investors we work with, and your
perspective is a helpful one.

K
Alex Bryan is director of passive strategies for North
America at Morningstar.

MORNINGSTAR'S PERSPECTIVE

Value and Profitability Work Better Together
There is more to value investing than simply
buying cheap stocks. Valuations alone don't paint
a complete picture of stocks' expected returns,
as low valuations could either point to low
future cash flows or high discount rates. The June
issue of Morningstar ETFInvestor explored
how combining valuations with information about
a firm's profitability can better identify which
stocks will likely have strong performance in the
future, as current profitability is predictive
of future cash flows.

valuations and profitability better isolates
differences in discount rates across stocks, which
should provide a better signal about which stocks
should perform well in the future.
ETFs that explicitly tilt toward profitable stocks
trading at lower valuations are few and far
between. While not a value fund, Avantis U.S.
Equity ETF AVUS tries to simultaneously emphasize
stocks trading at lower valuations and higher
profitability. As of June 2020, its price/book ratio
was below that of the Russell 1000 Index,
while its ROIC was similar. IShares Edge MSCI
Multifactor USA ETF LRGF also tilts toward
stocks trading at lower valuations and higher
profitability while also emphasizing names with
strong momentum and smaller market caps.

The matrix in the exhibit below was compiled using
data from the Ken French Data Library. It sorts
the historical performance of U.S. stocks by their
price/book ratio and operating profitability, and
shows that stocks trading at lower valuations and
higher profitability tend to outperform those with
the opposite characteristics. Across all five
valuation quintiles, stocks in the lowest-profitability
cohort underperformed those in cohort 2, often by
several percentage points per year. Simply avoiding
the least-profitable names can dramatically
improve performance over a value strategy that
does not consider profitability.

Funds that track Standard & Poor's value indexes,
like iShares S&P Small-Cap 600 Value ETF IJS
or iShares S&P 500 Value ETF IVE, might also be
worth considering. These indexes require new
constituents to be profitable to qualify for inclusion.
These funds have similar valuations to the
Russell 1000 and 2000 Value indexes, respectively,
but have noticeably higher profitability.

Value investing works on its own: Stocks with low
multiples tend to have high discount rates
and expected returns. Profitability also works well
because it signals which companies are
more likely to grow future cash flows. Combining

Daniel Sotiroff is a manager research analyst

with Morningstar.

The Intersection of Valuation and Profitability U.S. stocks that coupled
lower valuations with higher profitably (and vice versa) had superior
annualized returns.
Worst Performance

Best Performance

2-3
High P/B

2.88

7.96

8.68

9.32

11.02

6.24

9.31

9.74

11.17

11.90

6.73

9.25

11.26

12.64

14.12

8.84

10.02

13.14

12.08

12.15

Low P/B

10.69

13.23

13.85

14.08

12.44

Low Proﬁtability

High Proﬁtability

3-4

4-5

5-6

6-7

Source: Ken French Data Library. Data from July 1963 through April 2020.

7-8

8-9

9-10
61

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Morningstar - Q3 2020

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