- Value stocks are distinguished by lower-than-average price/book and price/earnings ratios.
- Value stocks across national boundaries and market caps have lagged broader averages since the Great Recession.
- There is no clear analytical explanation for the poor relative performance of value stocks.
- The empirical evidence for a value premium in the US large cap space has weakened.
- There is minimal downside to reducing value tilt for large stocks.
2020 has been a tumultuous one for the stock market. Equities fell precipitously after COVID-19 made its way to western countries. Yet markets recovered remarkably well with the implementation of aggressive fiscal and monetary stimulus. The US stock market is up comfortably during the pandemic largely on the performance of its surging high tech sector.
Market action during the pandemic has amplified a trend that has prevailed since the Great Recession. Value stocks, characterized by low price/book and price/earnings ratios, have underperformed growth stocks that are typified by high market valuations relative to current fundamental measures.
The persistent success of growth stocks has raised questions in the minds of evidence-based investors who have long believed that value equities delivered superior long-term results. There is a wealth of research documenting a "value premium" attributable to stock portfolios that trade at low prices relative to conventional accounting measures. Studies that span many decades across multiple national markets showed that these value stocks outperform the broader market.
Dissipating Value Premium
Recent results have not conformed to long-term trends. Since the Great Recession, value stock portfolios have substantially underperformed their growth counterparts. Let's review some basic aggregates first - the Russell 1000 Growth Index against the Russell 1000 Value Index.
It's fair to say that value stocks in the US are in a slump. In fact, academics that take a nuanced view of stock performance believe that this is a "historic" slump. Research Affiliates concluded that value stocks underperformed their growth counterparts by 55% from 2007 through mid 2020, and the lag continues as of this writing. This is the largest drawdown observed since 1963. Certainly worth another examination.
Many observers have forwarded hypotheses as to why growth stocks have done so well. Some have speculated that value is a victim of its own popularity. Its acolytes have crowded into the same value stocks and arbitraged away the value premium. However, a casual review of the data contradicts the theory. Over the past decade, value stocks have cheapened relative to their growth counterparts. If value stocks had become a "crowded trade", we would have seen a runup in those stocks as their price multiples were bid up by eager investors.
The opposite has occurred. By every metric, the gap between value and growth stocks has widened as the high growth companies have run away from the field. Consider the change in relative valuation in the just the last five years.
Some academics have argued that the measurement of value stock returns suffers from a specification problem. More specifically, GAAP rules are insufficient to capture the dynamism of today's modern information economy.
In today’s economy ... companies’ intangible assets - intellectual property, brand, patents, brands, software, human capital, reputation capital, customer relationships, and so forth - are often at the core of their ability to generate and maintain profit margins, yet are almost totally ignored by the book value. Book value only captures the traditional tangible capital locked in bricks and mortar and in financial assets such as cash and other securities.
There is some evidence that stocks classified as growth companies have accumulated more intangible assets on their balance sheets. If these intangible assets were estimated and added back to their book values, the recent gap between value and growth stocks would not nearly be so wide.
There are a number of problems with this explanation. Estimations of intangible assets are little more than guesses, at best. Research Affiliates imputes intangible corporate assets by amortizing R&D expenses plus 30% of SG&A as a long-lived asset. It's a sincere effort but hardly a precise one.
Dimensional Fund Advisors (DFA), another value investing shop, takes a broader and more skeptical view of the entire process.
Take a step back and ask: “Are internal intangibles a new phenomenon? And, if not new, have they grown in importance over time?” The answer to the ﬁrst question is no. History buffs will know that the US started issuing patents back in 1790 and registering trademarks in 1870. So intangibles have been part of the economic landscape and capital markets for a long time.
DFA went on to point out that the overall weight of intangible assets on corporate balance sheets has remained at about 30% since the 1980s. The apparent shift of intangible assets to growth companies is more directly an artifact of sector exposure rather than a story of migration to growth. In short, they are highly skeptical of an ad hoc re-specification of corporate balance sheets based on a trend that has been imprecisely measured for 10 or 15 years.
There are other, more anecdotal, objections to the value premium. Systematically low interest rates are said to favor growth companies. Investors typically anticipate that earnings of growth companies lie further into the future. Low discount rates benefit these speculative issues more as deeply receded payoffs become more relevant.
It's a narrative that has found some traction among market watchers. Indeed, the recent success of growth stocks has coincided with an extremely low interest rate environment.
The theory does have a couple of major drawbacks. Value stocks tend to be more levered. The Russell Value index has a debt/equity ratio that is roughly 10% higher than its growth counterpart. With more bonds, they should stand to benefit more directly from a drop in the cost of borrowing.
The low interest rate hypothesis does feel a bit contrived - it is articulated without resort to any kind of rigorous empirical analysis. We can at least review other periods of low interest rates to see if there is a corresponding negative impact on value stocks.
History has cooperated. Moody's maintains an index of long-term, high-grade corporate bond yields. It's averaged about 3.5% since 2015, about 2.3% lower than the 95 years preceding. However, such low rates are far from unprecedented. Long-term corporate bond yields were lower than 3.5% continuously from 1935 through 1956. And, during that time, value stocks performed quite well.
The chart below tracks the long-term corporate bond rate against the annual value premium in the US stock market. Value stocks outperformed growth stocks by over 7% during a 21-year low interest period. Yet comparably low interest rates today are being touted as a tailwind to high flying equities.
Value premium sourced at Kenneth French's data library, Dartmouth
It's difficult to identify a single silver bullet to refute or affirm the value premium. It has been showing up in financial markets all over the world for decades. Researchers from disparate backgrounds have documented it. Yet, for whatever reasons, the value premium seems to be weakening.
Some current research is more reserved in its endorsement of value stocks. The founding fathers of the value premium, Eugene Fama and Kenneth French, published a working paper in 2020 that casts some doubt on their original findings. They compared value premiums from 1963 through 1991 against those that followed the publication of their original 1992 paper - roughly the same time frame. The weight of recent data is clouding the issue.
The initial tests confirm that realized value premiums fall from the first half of the sample to the second...The high volatility of monthly value premiums clouds inferences about whether the declines in average premiums reflect changes in expected premiums. Comparing the first and second half-period averages, we don’t come close to rejecting the hypothesis that out-of-sample expected premiums are the same as in-sample expected premiums. But the imprecision of the estimates implies that we also can’t reject a wide range of lower values for second half expected premiums.
Fama and French recognized that the evidence of value premium has been weak since their paper was published, based on US data since the publication of their original paper in 1992. However, there is not yet enough data to establish that the value premium has disappeared altogether.
If we look at the returns of US large cap stocks since 1963 (the start of the Fama French dataset in the working paper), there is a positive value premium, but it is not statistically significant from zero. Keep in mind the US large cap market is not a niche market. The S&P 500 today subsumes about 40% of the world's market capitalization.
It's also relevant to note that the recent Fama/French working paper dataset ends in June 2019. Value stocks have underperformed massively in the past 18 months. This recent data is not yet reflected in the author's analysis.
Most American portfolio managers are heavily invested in large US stocks. It begs the question - how far back should we actually look to find data relevant to our own time? There is no easy answer.
Implications for Today's Portfolio Managers
Managers can be suspicious of the value premium without abandoning it altogether. After all, there is no serious researcher claiming that there is a growth premium. The relative performance of value is very much a function of the frame of reference under which it is examined. DFA's large cap value fund, DFLVX, has substantially lagged the SPDR S&P 500 ETF (SPY) over the past 10 years but performs relatively well since the turn of the millennium.
It may be time to adhere more closely to market value weighting. The S&P 500 and broader US market indicia (VTI) have been reliably strong performers for decades. If nothing else, the recent decade has revealed that value and growth portfolios can have enormous tracking error with respect to the S&P 500 and Russell 3000.
There are organic ways to reduce value tilt. Value funds tend to be less appreciated that pure index funds. For taxable portfolios, they are a tax efficient way to raise cash for clients. Similarly, dividends and capital gains can be disproportionately reinvested in index funds.
It's probably still worth employing some value tilt. The market action since the publication of the seminal work of Fama and French in 1992 has weakened the observable value premium. A reduced level of confidence suggests a lower weighting in that strategy.
This article was written by
Analyst’s Disclosure: I am/we are long SPY, VTI, DFLVX. 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.
Special Thanks to Dr. Gulseren Mutlu for her editorial input.
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