Time To Reconsider Value Stocks

by: Vladimir Dimitrov, CFA

Now is the second time in history when the S&P 500 outperforms the value factor by such a wide margin.

When S&P 500 and the value factor diverge, the risk of market correction increased significantly.

Yield starvation plays a key role alongside other factors such as disruptive technology.

Which stocks in the S&P 500 have the highest and which the lowest exposure to Fama and French factors.

Over the past few years, I have been reading vast amounts of research papers, articles, and analyses on how the stock market is massively overvalued due to vast amount of liquidity poured by central banks around the world and the zero interest policies adopted.

I have never had any doubts that this is the main reason why we are observing such high valuations these days, yet this doesn't provide any guidance on what kind of stocks are more likely to outperform over the next few years.

Whether the stock market explodes like a supernova, we witness the return of high inflation in developed markets, experience a lost decade just as Japan did in the 1990s, or we keep getting more of the same as in the last few years, I just don't know.

Whatever the scenario, the most sensible approach appears to be able to keep a large exposure in cash & cash equivalents (mostly in gold, in my case, why gold I cover in this article). And, the rest of the portfolio in common stocks, with the aim to gradually increase the equity share of the portfolio as/if the stock market corrects.

In this article, I will cover some points on why value stocks and stocks with high exposure to other factors might be a better solution than some of the most widely-owned growth stocks.

The Value Factor

Throughout the rest of the article, I will refer to Fama and French 5 factors as developed by Eugene Fama and Kenneth French.

I looked at each of the factors how it performed versus the S&P 500 as far back as the data availability allowed, i.e. since 1964.

I decided to start off with the value factor (HML), since value has been underperforming growth for quite some time now.

Source: kiplinger.com

Also, perhaps not as a surprise, Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) portfolio seems to be heavily exposed to the HML factor.

Berkshire Hathaway Inc. Top 10 Holdings as of Q1 2019

Source: Author's calculations based on Fama & French 5-factor portfolios; Berkshire Hathaway SEC Filings

The first graph looks at the indexed performance of the HML factor vs. that of the S&P 500 less the risk-free rate, again, as defined by Fama and French.

Source: Author's calculations based on Fama & French 5-factor portfolios and Yahoo Finance

The value factor seems to have been doing well for most of the time, with two notable exceptions that I will cover below.

To put all that into context, the next graph simply divides the S&P 500 indexed return over that of the HML factor.

Source: Author's calculations based on Fama & French 5-factor portfolios and Yahoo Finance

A few observations are:

  • up until the beginning of the 1980s, the relationship has been declining, i.e. value has been outperforming;
  • after that period, the relationship has reversed, and although value has continued to outperform for most of the time, the gap between HML and the S&P 500 has been narrowing;
  • with the exception of the dot-com bubble, the only other period when the S&P 500 was outperforming by that much is today;

Yield Starvation

So, why did the trend started reversing since the early 1980s?

At that time, 10-year government bond yields also reversed their upward trend.

10 Year Treasury Rate - 54-Year Historical Chart

Source: marcrotrends.net

It seems that the level of interest in the U.S. does have an inverse relationship with the S&P 500 outperformance over the HML factor:

Source: Author's calculations based on Fama & French 5-factor portfolios and Yahoo Finance

Since the year 1980, the level of interest in the U.S. has been gradually declining as did the S&P 500 performance vs. the value factor. Of course, this is just a long-term observation with a lot of noise in between. However, as bond yields decline, many institutional investors such as pension funds are forced to chase higher yields in growth equity stocks.

Plotting this relationship on an x-y axis also reveals something quite interesting.

Source: Author's calculations based on Fama & French 5-factor portfolios and Yahoo Finance

Most of noise is caused during years preceding large corrections of the S&P 500 index - the dot-com bubble of 2000-02, the crash of 1969-70, the crash of 1973-74.

On the other end of the scale (below the trend line), we have extreme periods such as 2008 and 1975.

If we exclude these extreme periods from our sample, the relationship between S&P 500 vs. HML factor performance and the level of interest would be much stronger.

Yield-starved pension funds and other institutional investors are more likely to get pushed into high growth stocks at times when the level of interest on their fixed income portfolio is not earning enough to cover the outflows.

Disruption and other factors

The first time when the S&P 500 outperformed the HML factor by a very wide margin was in 1999, just before the 2001/02 dot.com bubble, brought by the market's obsession with tech stocks. Disruption brought by the internet drove valuations to extreme levels.

Nowadays is the second time when the S&P 500 moved to the extreme against the value factor. Of course, we do observe a similar rhetoric these days with all the disruption, e-commerce, 5G, IoT, artificial intelligence etc. Although there are some parallels between now and 2001-02 period, the disruptors of the day are somehow more mature than those of the dot-com bubble. Companies like Amazon (NASDAQ:AMZN), Alibaba (NYSE:BABA), Facebook (NASDAQ:FB), Google (NASDAQ:GOOG) (NASDAQ:GOOGL) etc. do control almost every aspect of people's everyday life, not only in the U.S. but across the globe.

It's hard to call the rise of FAANG-like stocks the same as that of technology companies in the early 2000s. Nevertheless, excitement around disruption and new technology seems to be playing a role in taking some valuations to the extreme.

Excitement around new technologies and disruption seems to also correlate with S&P 500 concentration.

Image result for s&p 500 concentration

Nowadays, the top 10 companies in the S&P 500 make up 23% of the index (if we count Alphabet's class A and C shares as one), which is close to the heights of 1980s and 2000s.

Source: slickcharts

Proliferation of ETFs and passive investment strategies has further exacerbated the issue, creating a feedback loop similar to Soros' Theory of Reflexivity. Elevated market values of high growth stocks give them higher weightings within the indices and ETFs, thus attracting more volumes as money pours into ETFs.

Investors believing they are owning a well-diversified portfolio are nowadays getting more and more exposure to a handful of companies.

Source: marketwatch.com

At a time when share buybacks are reaching historical highs, some of the largest companies such as Alphabet and Amazon are actually increasing their total amount of shares outstanding.

Image result for amazon shares outstanding

Source: fairlyvalued.com

Source: fairlyvalued.com

This further accelerates the feedback loop, making it easier for such companies to grow through shifting operational expenses to stock compensation.

The rest of the Fama and French factors

As a matter of fact, similar to the value factor discussed above, all other Fama and French factors show a similar pattern when compared vs. the S&P 500 index:

  • the small company factor:

Source: Author's calculations based on Fama & French 5-factor portfolios and Yahoo Finance

  • profitability factor:

Source: Author's calculations based on Fama & French 5-factor portfolios and Yahoo Finance

  • and conservative investment factor:

Source: Author's calculations based on Fama & French 5-factor portfolios and Yahoo Finance

Which stocks have the highest/lowest exposure

After calculating the 5-factor exposure for each of the stocks in the S&P 500 index, I then scaled the sum of the four factors (SMB, HML, RWA, and CMA) by the exposure to the market factor (Mkt) to get an idea of which are the stocks most likely to have driven the anomaly we observe above in the years 2017 to 2019.

Heavily dominated by Information Technology companies, the list of the top 20 companies with lowest scaled factor performance over the market exposure, has all of the FAANGs in it:

Source: Author's calculations based on Fama & French 5-factor portfolios and Yahoo Finance

On the other end of the spectrum are predominantly consumer staples, utilities, and few retailers.

Source: Author's calculations based on Fama & French 5-factor portfolios and Yahoo Finance

And of course, same as last year, banks still occupy the top list with highest HML exposure.

Source: Author's calculations based on Fama & French 5-factor portfolios and Yahoo Finance

I guess there's no surprise why the most famous value investor Warren Buffett has such high exposure to U.S. banks.


This the second time in history when the S&P 500, less the risk-free rate, has outperformed the value factor by such a wide margin. The index outperformance is at record-highs against all other of Fama and French factors, excluding the market factor.

Although this does not guarantee that the trend will reverse any time soon, it illustrates the one-sidedness of the current bull market.

The almost-perfect storm for value stocks, caused by extremely low interest rates, technological innovation over recent years, and the rise of passive investment vehicles, has widened the valuation gap between growth and value to extreme levels.

If or when the market corrects, this gap would be more likely to narrow rather than expand.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Please do your own due diligence and consult with your financial advisor, if you have one, before making any investment decisions. The author is not acting in an investment adviser capacity. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.