The performance of U.S. value stocks over the last decade has led many to wonder whether the value premium has been completely eroded. New research from Boston-based Grantham Mayo Van Otterloo (GMO) shows that this was due to changes in relative valuations that favored growth over value, but now value stocks are priced attractively.
Relative valuations refer to the difference in metrics, such as price-to-book ratios, between value and growth stocks.
From January 2009 through June 2019, while the S&P 500 Index returned 14.3% per annum (total cumulative return of 307%), the Fama-French large-value and small-value research indexes returned 11.6% per annum (total cumulative return of 215%) and 12.5% per annum (total cumulative return of 245%), respectively. (Fama-French data is from Ken French’s website.) I took a deep dive into this issue in my June 4, 2019, post at Alpha Architect. I also specifically looked at the relative valuations of small-value stocks in my August 8, 2019, article for Advisor Perspectives – demonstrating that, from a historical perspective, there is no evidence of overcrowding in small-value stocks, and in fact they look relatively cheap.
The research team at GMO contribute to the discussion with their analysis of the performance of the value premium – decomposing the relative returns of cheap stocks in order to understand what has driven this change in performance. They began by examining the gap in growth rates of value companies relative to the market. They noted that while value companies (cheap stocks) have historically had lower growth rates in book value, sales and gross profits, nothing has been exceptional about the most recent period.
In other words, there is no indication that a structural shift has occurred that has disproportionately hurt cheap stocks’ historical growth.
Have value stocks become riskier?
GMO next examined whether the quality of value stocks has deteriorated (through increasing leverage and/or reduced profitability). Such a deterioration should lead to a widening of spreads between value and growth stocks (explaining the poor performance of value companies). However, they found, “When GMO’s Asset Allocation team looks at the relative quality of value, however, this doesn’t seem to hold; value’s quality today is at parity with that of the broad market, and in relative terms it is above its early sample average.” They concluded: “All in all, growth does not seem to be any more of an issue for value stocks than it has ever been. Though cheap companies grow less than the market, this is not a new phenomenon. Moreover, these stocks are carrying relatively low leverage (both from an absolute and from a relative perspective), and market expectations on their future relative growth look no worse than normal. The underperformance of cheap companies doesn’t look to stem from an unexpected shock to fundamentals.”
Has overcrowding killed the value premium?
In the post-2005 period, GMO found that changes in valuations had negatively impacted the value premium by 1.1% per annum – the spread between the valuation of growth and value stocks had widened, not narrowed (which would have been the case if overcrowding had occurred). They noted that the widening occurred because, in the post-crisis period, valuations of growth stocks increased more than they did for value stocks. They added that this should be expected, as growth stocks (with more of their earnings in the future) are longer duration stocks. GMO noted that “Relative multiples are now lower than in 90% of months since 1981.” They added, “Using price-to-book data from 1928 onward, we find that variations in value’s relative multiple indeed tend to be negatively associated with changes to market valuations.” In other words, valuation spreads tend to widen during “risk on” periods, when discount rates fall, and narrow during “risk off” periods, when discount rates rise.
GMO also examined the impact of rebalancing on the value premium.
Rebalancing
What many investors may not be aware of is that much of the historical value premium has resulted from the migration of stocks from value to growth and vice versa. GMO found that in the post-2005 period, “Stocks in between the cheapest and most expensive stocks have been looking a bit less mobile.” Thus, rebalancing returns have suffered – their contribution to the value premium, GMO found, fell from about 4% from 1981 through 2005 to about 3.3% afterwards. Perhaps the slower rate of migration is permanent due to some structural change in the economy. If that’s the case, all else equal, it would suggest a somewhat smaller rebalancing benefit going forward, and a smaller value premium.
Summarizing their findings, GMO concluded: “The main headwind for value as a group over the past 13 years has been its widening discount, with valuations alone accounting for roughly 50% of the group’s performance deterioration during this period.” They added: “But valuations are not likely to move against cheap stocks forever. Though it is possible for relative multiples to draw down further, this would require either a change in growth expectations, a continued reduction in market discount rates, or an expansion of the value premium.”
Conclusion
The value premium has not materialized over the last decade for a simple reason: relative valuations. Relative valuations could widen even more (for example, the discount rate could fall further, helping longer duration growth stocks over shorter duration value stocks). However, based on the historical evidence, the odds favor that cheap stocks will provide a premium going forward. And if relative valuations revert to their long-term mean, the value premium will look valuable indeed.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.
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