Opposite Ends of Value: The Hidden Risks in Value Indexing

Morningstar’s push years ago to get our industry thinking in terms of the nine style boxes continues to provide a framework for differentiating investment options. However, if you dig a little deeper, it’s far more complex than just the nine style boxes. Given the sheer number of public companies today, the constituents of a single style box can present vastly different investment prospects. For example, a mega cap can be seen as much different than a large cap, though they reside in the same box. Likewise, a micro cap will differ from a small cap despite being in the same style box. And so on.

Similarly, it’s difficult to assume that we can simply break style into three categories: value, core, and growth. We contend that the style universe is much more complex. Not all value or growth companies are the same, and we often cannot make apples-to-apples comparisons of a single style box’s constituents. Instead, we propose the following style spectrum:

Deep/Contrarian Value - Relative Value - Core - Traditional Growth - Aggressive/Momentum Growth

Deep Value vs. Relative Value

Deep value stocks are generally companies that, for whatever reason, are trading at a discount to their market value in the mind of the portfolio manager. There are many ways that “deep value” has been expressed within our industry: “it’s like buying dollars for 50 cents,” or others may say that “the company is misunderstood and the market isn’t seeing its value.” In the end, the assumption is based on price and not underlying quality or fundamentals. Some may say this very same stock “looks cheap” for a very good reason.

Relative value stocks are companies that trade at a discount to their intrinsic value when compared to like assets within their specific peer group. This style tends to be on the right side of the value box. Other characteristics might include higher growth levels, other shareholder value sources like dividends and buybacks, and possibly a more market-like price-to-earnings multiple. An active investment manager may consider more forward-looking indicators to assess a company’s growth potential and intrinsic value.

For Large Cap Value, a mutual fund or Exchange Traded Fund (ETF) that tracks the Russell 1000 Value Index can be considered a traditional investment option. As an asset class, Large Cap Value historically receives a large % of an average investor’s allocation versus other equity asset classes. However, the makeup of the index is what some might regard as overall low quality- low growth and higher debt but possibly trading at a value to underlying intrinsic value. As of 12/31/22, 80% of the index holdings’ debt ratings are BBB or lower, including 27% of the index that would qualify as a junk-rated balance sheet. Quantitatively, the price-to-earnings multiple may be the definition of value, and comparing the discount of that asset to the overall market may lead an investor to think that a price appreciation to at least the market average is imminent.

Picture1 As of 2/28/2023. Orange dots represent index constituents. The green-shaded area reflects the portion of the Russell 1000 Value Index containing low Price-to-Book companies with strong financial health.
Picture3 As of 2/28/2023. Orange dots represent index constituents. The green-shaded area reflects the portion of the Russell 1000 Value Index containing low Price-to-Book companies with positive earnings growth.
Picture4 As of 2/28/2023. Orange dots represent index constituents. The green-shaded area reflects the portion of the Russell 1000 Value Index containing low Price-to-Book companies with a positive level of profitability.

When deciding on the right allocation for the value portion of your portfolio, it’s important to understand the hidden risks that may be lurking within the Russell 1000 Value Index. While this index may appear to be a traditional value investment option, the low-quality companies within its makeup can pose a significant risk to your portfolio.

About Madison Dividend Income

Led by 35-year veteran value portfolio manager John Brown, the Madison Dividend Income strategy embraces a relative value approach to build an all-weather portfolio of high-quality stocks with dividend yields greater than the S&P 500 Index.

“Madison” and/or “Madison Investments” is the unifying tradename of Madison Investment Holdings, Inc., Madison Asset Management, LLC (“MAM”), and Madison Investment Advisors, LLC (“MIA”). MAM and MIA are registered as investment advisers with the U.S. Securities and Exchange Commission. Madison Funds are distributed by MFD Distributor, LLC. MFD Distributor, LLC is registered with the U.S. Securities and Exchange Commission as a broker-dealer and is a member firm of the Financial Industry Regulatory Authority. The home office for each firm listed above is 550 Science Drive, Madison, WI 53711. Madison’s toll-free number is 800-767-0300.

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Price-to-Book Ratio: measures a company’s stock price in relation to its book value (the total amount raised if its assets were liquidated and paid back all its liabilities).
5-Year EPS Growth: the annual rate at which a company’s earnings have grown over the past five years.

Return on Equity (ROE): a profitability ratio that measures the amount of net income returned as a percentage of investors equity.

The Morningstar Style Box™ was introduced in 1992 to help investors and advisors determine the investment style of a fund. The Equity Style Box is a nine-square grid that classifies securities by size along the vertical axis and by value and growth characteristics along the horizontal axis. Different investment styles often have different levels of risk and lead to differences in returns.

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