Overview
2018 marked another year in which U.S. value stocks underperformed relative to the market (and, of course, growth stocks). Value stocks have trailed the market in 9 of the last 12 years by an average of 2.0%1 per year. This value deficit during this most recent cycle stands in contrast to the long-run premium generated by buying cheap stocks.2 Decomposing returns suggests the value premium stems from multiple drivers of relative performance and recent underperformance comes from a variety of those sources, not one sole culprit. We believe many of these effects have been time-specific and will revert to value’s favor, making this a particularly attractive time to lean into the value style. To be fair, our research suggests some historical value drivers may in fact provide less benefit going forward. This combination leaves us confident that value stands well-positioned over the mid term, but may not be able to match its historical levels of outperformance over the longer run.
This note, in which we analyze the drivers of value’s historical outperformance, is intended to serve as an appetizer to a more comprehensive research paper my colleague John Pease will be publishing soon. John’s work suggests that value’s recent underperformance is not due to an erosion in the fundamental growth of value stocks. Value fundamentals – the group’s historic level of under-growth – have been consistent with history. Instead, value stocks have accrued less benefit from higher relative income and the rebalancing effect. Moreover, value has experienced a negative valuation impact because cheap stocks have not seen their multiples expand as much as the broad market during this recent cycle. As a result, we believe value stocks are priced to outperform across all regions.
First, why does value work?
By definition, value stocks trade at a discount to the market. The value universe comprises companies with lower-than-average fundamental growth, causing investors to demand a discounted valuation. Investors systematically underestimate the ability of weaker and distressed companies to mean revert to profitability
and reasonable growth levels. Instead, they overpay for growth by extrapolating relatively strong growth too far into the future. Historically, buying companies with low price multiples has delivered substantially better returns than the overall market, with the added benefit of lower absolute volatility. From the inception of the Russell 3000 Value index through 2006, value stocks outperformed the broad market in the U.S. by 1.1% per year starting in 1978. While value companies did in fact under-grow the market, their cheaper valuations, higher yields, and a number of other factors more than made up for their weaker fundamentals.
Over the past 12 years, however, value stocks have underperformed, leaving many to ask whether the value premium is gone (see Exhibit 1). Let’s answer that question by starting with what we know hasn’t been the issue in the decline.
Fundamental growth continues to lag the market… as it always has
As the chart above indicates, value company fundamentals (sales, gross profit, and book value) have grown 2.3% more slowly than the broad market since 2006.3 This level of undergrowth was to be expected and was in line with the group’s long-term history. As value’s fundamentals were neither better nor worse than history, other return drivers must explain underperformance over the past decade.
Income advantage is lower in an expensive market
One way value stocks have outperformed over the long run is by offering higher than market yields. That advantage diminishes in an expensive market like today’s. If the broad market traded at a 4% yield with value stocks offering a 50% yield premium, the yield on the value universe would be 6%. Cheaper valuations allow the value cohort to offer 2 points of additional yield, a helpful offset to value’s historical undergrowth. If the market doubled (and value retained its 50% yield advantage), the 2% of extra yield from value falls to a less attractive 1% advantage (with the market yield falling to 2% and value to 3%). In an expensive market, value’s yield advantage compresses. This has certainly been the case over the last 12 years, particularly in the U.S., where the market has been quite expensive. The combination of dividends and share repurchases provided 0.8% less relative return for value stocks compared to its longer history.
Our base case equity forecasts assume multiples mean revert to long-term historical averages. If, however, markets have in fact entered a new secular paradigm with higher price multiples lasting in perpetuity, the overall value premium would be lessened due to a smaller income effect.
Continue reading here.
