This value-stock strategy has excelled, even before the 'Great Rotation'

By Philip van Doorn

A momentum filter can help you avoid 'value traps' among stocks that trade low to earnings

The "Great Rotation" that has played out over the past month may be the start of a long-term trend. This is because the parts of the stock market that had been overlooked through the first half of the year are still cheaply valued relative to the Big Tech-dominated S&P 500.

One strategy that seems especially appropriate for this moment is outlined below.

The rotation to value and smaller companies might have a long way to go

There is much to take in when looking at the July rotation from Big Tech and other large growth-oriented companies.

Here are some performance figures for exchange-traded funds that track several well-known stock indexes. These include total returns with dividends reinvested for the first 30 days of July, for the first half of 2024 and for longer periods through June:

   ETF                                Ticker   Total return from June 28 through July 30  2024 through June  3 years through June  5 years through June 
   SPDR S&P 500 ETF Trust              SPY                                         -0.4%              15.2%                 32.9%                101.1% 
   Invesco S&P 500 Equal Weight ETF    RSP                                          4.0%               5.0%                 14.6%                 66.6% 
   iShares Core S&P Small Cap ETF      IJR                                         10.3%              -0.8%                 -1.1%                 46.9% 
   Vanguard S&P Mid-Cap 400 ETF        IVOO                                         5.2%               6.1%                 13.7%                 62.2% 
   iShares Russell 1000 Growth ETF     IWF                                         -4.3%              20.5%                 37.2%                140.6% 
   iShares Russell 1000 Value ETF      IWD                                          4.9%               6.5%                 16.9%                 52.9% 
                                                                                                                                        Source: FactSet 

The S&P 500 SPX is a growth-oriented index because it is weighted by market capitalization. This means that the SPDR S&P 500 ETF Trust SPY is 19.4% concentrated among three companies (Microsoft Corp. (MSFT), Apple Inc. (AAPL) and Nvidia Inc. (NVDA)) with the largest 10 companies making up 35.1% of the portfolio.

It is clear that investors' interest has broadened recently, based on the strong performance of the Invesco S&P 500 Equal Weight ETF RSP relative to the cap-weighted SPY in June and July.

And from the remaining ETFs on the list, you can see that value stocks, small-cap stocks and mid-cap stocks all fared well as the S&P 500 declined slightly during the first 30 days of July, led by a 5.8% decline for its information-technology sector.

Now take a look at how forward price-to-earnings ratios for the three broad S&P indexes compare with their longer-term averages:

   Sector or index      Forward P/E  Forward P/E one year ago  Current P/E to 5-year average  Current P/E to 10-year average  Current P/E to 15-year average 
   S&P 500                     21.3                      19.8                           108%                            117%                            129% 
   S&P Mid Cap 400             15.6                      14.7                            99%                             98%                            101% 
   S&P Small Cap 600           15.0                      13.0                           100%                             98%                            101% 
                                                                                                                                             Source: FactSet 

The S&P 500 is trading well above its 10-year and 15-year average forward P/E levels. These are index prices divided by rolling weighted 12-month earnings-per-share estimates among analysts polled by FactSet. The S&P Mid Cap 400 MID and the S&P Small Cap 600 SML indexes are trading in line with their long-term P/E averages.

Earlier this week, John Buckingham, the editor of the Prudent Speculator newsletter, made a broad comparison of prices using the growth and value subsets of the Russell 3000 Index RUA, which represents 98% of publicly traded U.S. companies by market cap:

Buckingham cautioned that value-oriented investors have gotten excited before, only to see growth strategies continue to outperform. He also wrote that we might still be in the early stage of a market rotation away from growth stocks: "Here is a tremendously long way to go (which is a very good thing for future appreciation prospects) before Value would even return to equilibrium."

Read: Will the stock market's 'Great Rotation' continue? These three things could decide its fate

Tempering a small-cap value approach with a momentum filter

The Invesco S&P SmallCap Value with Momentum ETF XSVM underwent a change to its current strategy on June 21, 2019. Here is how it has performed since that date, compared with all of the ETFs in the first table above:

This rather busy chart shows that only the iShares Russell 1000 Growth ETF IWF has outperformed the Invesco S&P SmallCap Value with Momentum ETF since the latter adopted its current strategy. So far during July, XSVM has returned 11.7%, outperforming all others. All performance figures on the chart include reinvested dividends, and are net of expenses. XSVM's annual expenses total 0.36% of assets under management.

One concern an investor might have about a successful fund is that "chasing performance" might lead to poor returns over time, as a strategy that is successful one year might "revert to the mean" the following year. But this fund's 120-stock portfolio is reconstituted every six months, on the second Fridays of June and December, as follows:

The iShares Russell 1000 Growth ETF tracks the S&P SmallCap 600 High Momentum Value Index, which is maintained by S&P Dow Jones Indices.The analysis begins with the S&P Small Cap 600 index, which itself is more selective than the Russell 2000 Index RUT, which is often used as a small-cap performance benchmark. The Russell 2000 has no requirements for a company to be included - it is simply the smallest 2000 stocks in the Russell 3000, by market cap. It includes hundreds of unprofitable companies. S&P Dow Jones Indices has criteria for a company to join the S&P Small Cap 600, which include four quarters of positive net income. Every six months, the index is reconstituted based on value and momentum scores. First, each stock in the S&P Small Cap 600 Index is assigned a composite score encompassing these valuation ratios: Earnings to price, sales to price and book value to price. The list is cut to the 240 stocks with the highest valuation scores.Then, for the momentum filter, the 240 remaining stocks are ranked by their risk-adjusted price gains over the previous 12 months, excluding the most recent month.The 120 stocks with the highest momentum scores are then weighted by their valuation scores for the index and for the XSVM portfolio

Nick Kalivas, head of Invesco's factor strategies for ETFs, said in an interview with MarketWatch that the momentum component of the stock selection is designed "to try to avoid value traps." A value trap describes a scenario in which a stock has traded at a low valuation (or with a high dividend yield) for good underlying reasons. Investors looking for bargains might find themselves holding shares that continue to slide over the long term as a company's business withers.

When considering the Russell 3000 growth-to-value price comparison, Kalivas said there had been "extreme outperformance for growth, for lack of a better term."

He cautioned investors about "a mean reversion argument," but also suggested that investors "think about having a durable portfolio and not be so underweight value or small-caps."

"There might be too much of a focus on megacap growth, given what we have seen recently, Kalivas said.

Keeping in mind that weightings in the portfolio reflect price changes since the Invesco S&P SmallCap Value with Momentum ETF underwent its semiannual reset in June, here are the fund's largest 10 holdings:

   Par Pacific Holdings Inc.        Ticker   % of XSVM portfolio 
   Kelly Services Inc. Class A      KELYA                   1.8% 
   Kohl's Corp.                      KSS                    1.6% 
   Bread Financial Holdings Inc.     BFH                    1.5% 
   StoneX Group Inc.                 SNEX                   1.5% 
   Par Pacific Holdings Inc          PARR                   1.5% 
   Andersons Inc.                    ANDE                   1.4% 
   ODP Corp.                         ODP                    1.4% 
   Group 1 Automotive Inc.           GPI                    1.4% 
   Titan International Inc.          TWI                    1.3% 
   Jackson Financial Inc. Class A    JXN                    1.3% 
                                                Source: Invesco 

Stock screens tied to the Great Rotation:

13 value stocks for patient investors looking for long-term growth20 value stocks scoring highest for long-term returns on invested capitalThis S&P 500 sector is expected to grow profits most rapidly through 2026 - and it's not tech. Here are 14 related stocks.20 value stocks with high dividend yields and expected room to raise payouts

-Philip van Doorn

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08-03-24 0811ET

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