• Small companies – over time they have a greater expected return than large companies
• Value companies – over time companies with a low relative price have a greater expected return than growth companies with higher price
• Companies with higher profitability – over time they have a greater expected return than stocks with low profitability.

This article has been written for those of our clients who are interested in knowing more on our thoughts on the returns of Value Stocks.

This article is a little more technical than those we would normally write for our clients, but we feel the detail is in this case warranted.

Brief Summary

• Value has underperformed Growth in recent years
• If markets work well, which we know they do, then it is rational to expect a premium for holding an overweight to value stocks in portfolios.
• There are behavioural and risk-based explanations for why the value premium exists, both of which achieved recognition as Nobel-prize winning research. The academic evidence is strong.
• The value premium appears to be consistent across time and markets. As the holding period increases, the probability of the premium showing up also increases. As with the equity risk premium, there is a chance that value underperforms growth for extended periods of time
• We remain confident in the value premium – patience and fortitude are required – a long term hold approach will pay dividends

The Detail

In recent years, the expected risk premium from ‘value’ stocks – those with low prices relative to some measure of company value – has come into question in some quarters. The performance of these firms has been somewhat underwhelming, when compared to their more expensive counterparts – ‘growth’ stocks. The quote below explains the basic premise for value stocks

‘The basic principle at work is that if you have an investment that has a low price, relative to the future expected wealth it may generate for you, it has a high expected return. That basic economic principle is supported by a preponderance of evidence… It applies to bonds, it applies to stocks, it applies to commodity futures, it applies to a lot of different things. If you stop believing in value, basically you stop believing in lots of what makes the world go around.’     
Gerard O’Reilly, PhD. CIO, Dimensional Fund Advisors.

Value stocks may kick you when you are down

The market crash earlier in the year, following the outbreak of COVID-19 has exacerbated what was already a decade-long negative premium for value stocks, despite strong absolute returns. The relatively more expensive growth companies have held up reasonably well and some of the larger firms delivered, quite frankly, astounding returns – for example, Apple, Amazon, and Tesla are up 64%, 81% and 429% respectively as of 9th October 2020. Given their colossal sizes, such firms make up a material allocation to global indices constructed on a market-capitalisation basis and dominate the returns of the MSCI World Growth Index. The ‘Big Five’ plus Tesla constitute 28% of that index, which contains 770 firms in total as of October 2020.

Data source: Financial Express Analytics

The underperformance of value during economically challenging periods is not a new phenomenon and somewhat expected given the characteristics of the companies that tend to make up this cohort. Value stocks are often described as being ‘out of favour’ and may be experiencing financial distress. As a group, these firms tend to have weaker balance sheets, with a larger portion of assets being financed by debt.

On the other hand, there have been challenging periods for investors where value stocks have held up relatively well, The Tech Wreck being the most significant example. With the advent of the digital age in the 90’s, access to the internet began to shift from luxury to necessity. Hundreds of glamourous ‘.com’ firms saw massive growth following IPOs only to give up all gains in late 2000 to 2001. Investors were willing to pay extremely high price multiples to participate in the upside of these companies and thus, they made up the bulk of growth stocks at the time. Many of these companies did not survive when markets plummeted and no longer exist today. Value investors were left relatively unscathed and experienced a large, fast premium. Warren Buffet famously stuck to his own value strategy during this period and reaped the rewards.

Table 5-1: US Market/value performance during top 10 drawdowns – Jul-26 – Aug-20

Data source: Dimensional Returns Web © All rights reserved. Monthly returns in USD. Indices: Fama/French Total US Market Research Index, Fama/French US Growth Research Index, Fama/French US Value Research Index.

Behavioural economists, such as Robert Shiller and Nobel laureate Richard Thaler, might refer to events such as the Tech Wreck as asset pricing bubbles whereby investors bid-up the prices of certain firms far beyond a rational valuation. Therefore, when markets revert and a more rational price is reached, value investors should experience a premium. Proponents of Eugene Fama’s efficient market hypothesis, also Nobel-prize winning research, would argue that these periods are caused by investors changing their future expectations (to earnings and discount rates) over time as new information is released. In turn, market prices adjust, often extremely quickly. Value stocks may help during the tough times or they may not.

The value premium around the globe

A useful finding from academia is that the value premium appears to be consistent across both time and markets. This is both encouraging and intuitive given that free capital markets are broadly driven by the same underlying mechanisms, regardless of border. In 1996, Fama and French extended their original US-centric research to test the prominence of the value premium in other developed and emerging nations including the UK and Japan. Using stock level data from MSCI between 1975 and 1995, they found a positive and significant value premium in 12 of 13 major developed markets. Furthermore, using the relatively short available emerging markets data at the time between 1987 and 1995, they found significant value premiums in 12 of 16 countries.

‘Value stocks tend to have higher returns than growth stocks in markets around the world. Sorting on book-to-market equity, value stocks outperform growth stocks in 12 of 13 major markets… There is also a value premium in emerging markets. Since these results are out-of-sample relative to earlier tests on U.S. data, they suggest that the return premium for value stocks is real.’ Eugene F. Fama and Kenneth R. French.

Embedded challenges in MSCI’s indices

These numbers do not tell the full story. MSCI’s broad market indices cover only the top 85% of market-cap within each country. These indices are dominated by large-cap stocks, have few mid-cap stocks and no small-cap exposure to speak of. A material portion of the investible opportunity set is therefore not captured. For example, there are 1,607 stocks in the MSCI World Index compared to 11,611 stocks in the MSCI World All Cap Index, which covers 99% of the investible universe. This is important as, on average, smaller companies tend to exhibit more value-like characteristics – they trade at lower prices – and have exhibited a stronger value premium over the longer term.

As with many other areas of the investment industry, index and product providers alike disagree on how best to define and apply the value risk factor in their offerings. This can make for challenging analysis, as one is often comparing ‘apples-to-pears’

Conclusion

We remain confident in the value premium – patience and fortitude are required.

Risk warnings

This article is distributed for educational purposes and should not be considered investment advice or an offer of any security for sale. This article contains the opinions of the author but not necessarily the Firm and does not represent a recommendation of any particular security, strategy, or investment product.  Information contained herein has been obtained from sources believed to be reliable but is not guaranteed.

Past performance is not indicative of future results and no representation is made that the stated results will be replicated.