VLUE: A Tech-Oriented Value Portfolio With Outperformance Potential (BATS:VLUE)

iShares Edge MSCI USA Value Factor ETF (BATS:VLUE) is an exchange-traded fund that enables investors to get exposure to mid- and large-cap U.S. stocks with lower fundamental valuations. The fund’s benchmark index is the MSCI USA Enhanced Value Index. The expense ratio is 0.15%, which is not super-cheap, but low-cost as compared to plenty of other funds (including iShares funds) that have nicher strategies.

VLUE had assets under management of $12.6 billion as of March 4, 2022 (with 150 holdings). This follows a year of net outflows that were “back-loaded”, as you can see illustrated in the chart below.

Value-oriented strategies tend to do well when long-term interest rates are on the rise. Lower-priced stocks tend not to “benefit” from higher long-term earnings growth expectations, hence their lower valuations. Higher rates can hurt growth stocks, whose earnings are expected to be higher in future (i.e., higher rates driven down the net present values of these stocks more harshly), which can drive rebalancings into so-called value stocks. Recently, long-term rates have softened, and so the value thesis is not looking as exciting.

This is also interesting from another perspective besides valuations; lower-growth and more mature markets could be viewed as a “safer” alternative to higher-risk growth markets (i.e., Cyclical and Defensive sectors vs. “Sensitive” sectors like Technology). The fact that markets have sold off recently, but value stocks are not in vogue, suggests a slight imbalance in how the market might conventionally price risk. You might have expected value equity funds like VLUE to at least find some stability amidst broader market declines.

Having said that, while VLUE is off its highs, the ratio between the price of VLUE and SPDR S&P 500 Trust ETF (SPY), the latter tracking the broader U.S. equity market (its benchmark being the S&P 500), is still up year-to-date.

The fundamental factors that drive stock selection within VLUE’s benchmark index, and thus within VLUE, are: Price-to-Book, Price-to-Forward Earnings, and Enterprise Value-to-Cash flow from Operations. So, this attracts stocks within its portfolio that are generally naturally in more mature markets. Having said that, VLUE matches broader market indices in respect of its high allocation to Technology stocks; this surprisingly represented 29.60% of the fund as of March 2, 2022.

Bear in mind that this large Tech exposure is comprised in large part by still-mature companies within the Tech stock universe. Four names in particular here, are Intel Corporation (INTC), Cisco Systems, Inc. (CSCO), Micron Technology, Inc. (MU), and IBM (IBM). These four stocks represented about 16% of the VLUE portfolio as of recent.

The top 10 holdings, including those four names, are illustrated below; collectively they represented about 36% of the VLUE portfolio as of March 4, 2022. For a fund with 150 holdings, this is actually not too concentrated.

To value VLUE, I am going to refer to the fund’s benchmark index factsheet as of February 28, 2022 (hyperlinked in the first paragraph of this article), which carried a trailing price/book ratio of 1.82x, and a forward price/earnings ratio of 10.12x. This implies a forward return on equity of 17.98%, which is pretty high for an apparently value-oriented fund (the most mature sectors are often in the ROE range of around 10-15% in the U.S.). This is helped by the larger-than-expected (perhaps) tech orientation.

Morningstar currently pegs three- to five-year earnings growth rates at circa 16.82%, which is on the high side. VLUE’s benchmark prices forward one-year earnings growth at less than 12%. I would prefer to err on the side of caution, as a longer-term pickup in earnings growth rate would therefore require some acceleration beyond year one, which I would prefer not to assume for the sake of our initial analysis. I will therefore base my earnings growth rate beyond year one at 10% through to the terminal year.

Meanwhile, the cost of equity for this kind of fund is going to be (by my estimate) a function of the mature market equity risk premium (for the United States) of 5.37% estimated by Professor Damodaran for March 2022 (elevated in light of recent risk aversion). The relative risk as estimated by beta for VLUE is circa 1.13x, so I will re-rate the ERP of 5.37% upward by 13%. And then finally, for the risk-free rate, I will refer to current U.S. 10-year yield of 1.7358%. Our cost of equity/required return comes to 7.80%.

As a result of these inputs, I arrive at a slightly strange outcome of upside potential of circa 89%.

This is probably because we have a high average underlying return on equity and decent earnings stream (even if I underestimate earnings growth in relation to the Morningstar analyst consensus), coupled with a relatively low cost of equity in line with reasonably low beta, probably helped by VLUE’s investment in variously mature businesses. Still, at the portfolio level, VLUE does look cheap.

On the other hand, recent outflows have clearly elevated the implied cost of equity here beyond what we might consider as being “fair”. If I were to solve for the current share price, the implied cost of equity would not be my implied 7.80%, but rather 14.01%. To be honest, it is difficult for me to attack this; I think VLUE is definitely undervalued. The implied “beta” in this scenario is over 2x as risky as the broader market if we strip out the 10-year yield component. Even if VLUE were to reprice as being roughly 1.5x as risky as the broader market (keeping my circa 10% average earnings growth rate), upside potential of just under 50% would still remain at present prices.

On a longer-term time frame, i.e., since fund inception, VLUE has struggled to outperform funds like SPY meaningfully for any distance (see the VLUE/SPY share price ratio below; since inception of VLUE in Q2 2013).

However, the bottom in this ratio was registered in August 2020. With VLUE beating SPY so far this year, I think this could potentially be the beginning of further outperformance this year. Whereas most tech-oriented funds are on the pricier side, VLUE seems like an attractive and well-constructed portfolio, with an appropriate level of diversification.