Value Devalued?
These have been challenging times for value stocks. Over the 10-year period ending March 31, 2020, the Fama/French US Value Research Index returned an annualized 5.06%, well behind the 13.04% achieved by the Fama/French US Growth Research Index. This performance divergence has resulted in a substantial widening of the price-to-book spread between value and growth stocks in the US, as shown in Exhibit 1.
EXHIBIT 1
Spread’s Up
Aggregate price-to-book ratios for value stocks vs. growth stocks, US market, July 1926–March 2020
Source: CRSP and Compustat. Stocks are sorted on book-to-market ratio each June, where book-to-market for year t is computed using the book equity for the last fiscal year end in t-1, divided by market equity for December of t-1. Value and growth are stocks with book-to-market ratios above and below the 70th and 30th percentiles for NYSE stocks, respectively. Aggregate price-to-book value computed as the inverse of the weighted average book-to-market ratio where market equity is for the current month.
Extending this analysis to different markets and asset classes reveals further evidence of widening valuation spreads between value and growth. As we see in Exhibit 2, spreads among large cap stocks in the US, non-US developed, and emerging markets have all generally expanded over the past decade. This was also true for small cap stocks in the US and non-US developed markets, with only emerging markets small caps bucking the spread-widening trend.
EXHIBIT 2
Widespread Growth
Aggregate price-to-book ratios across markets
Source: CRSP, Compustat, and Bloomberg. Aggregate price-to-book value computed as the inverse of the weighted average book-to-current month to date market value.
Size definitions: Stocks sorted using market equity as of each June. In the US, small caps and large caps are defined relative to the median market capitalization of stocks listed on the NYSE. In non-US developed markets, large cap and small cap represent the top 90% and bottom 10%, respectively, of aggregate market capitalization. In emerging markets, large cap and small cap represent the top 90% and bottom 10%, respectively, of aggregate market capitalization within each country.
Value definitions: Stocks are sorted on book-to-market ratio each June, where book-to-market for year t is computed using the book equity for the last fiscal year-end in t-1, divided by market equity for December of t-1. In the US, value and growth are stocks with book-to-market ratios above and below the 70th and 30th percentiles for NYSE stocks, respectively. In non-US developed markets, value and growth are stocks with book-to-market ratios above and below the 70th and 30th percentiles for large cap stocks in each region (Japan, Asia Pacific ex Japan, Canada, and Europe). In emerging markets, value and growth are stocks with book-to-market ratios above and below the 70th and 30th percentiles for large cap stocks in each country.
What do we make of the valuation ratio data? A stock’s price represents the value of a company’s expected future cash flows discounted back to the present. So low valuations can result from low expectations of future cash flows, high discount rates, or a mix of the two. It’s not possible to cleanly isolate cash flow and discount rate effects from the data. But to the extent that low valuations reflect high discount rates, expected returns will be higher going forward.
To the extent that widening spreads between value and growth are attributable to increases in the discount rates for value relative to growth, the implication would be a higher expected value premium. However, research from Dai (2016)1 suggests investors should be cautious using valuation spreads as inputs for asset allocation decisions. While regression analysis provides some evidence of a link between valuation spreads and subsequent value premiums, hypothetical timing strategies that switch between value stocks and growth stocks based on the spread in their valuations fail to consistently outperform a simple buy-and-hold value strategy.
What’s the takeaway for investors? Even if the spreads in valuations between value and growth vary through time, the important part is that there is a spread. Investors demand different expected returns across stocks, and that shows up in part through different valuations. It’s reasonable to expect that securities with lower prices relative to fundamentals should have higher expected returns. While value premiums may not show up every day, year, or decade, we believe maintaining consistent exposure to value stocks is the most robust approach for capturing the value premium, regardless of current valuations.
FOOTNOTES
1Wei Dai, “Premium Timing with Valuation Ratios” (white paper, Dimensional Fund Advisors, 2016).
GLOSSARY
Price-to-book ratio: The ratio of a firm’s market value to its book value, where market value is computed as price multiplied by shares outstanding and book value is the value of stockholder equity as reported on a company’s balance sheet.
Value stock: A stock trading at a low price relative to a measure such as book value or earnings.
Value premium: The return difference between value stocks and growth stocks.
Growth stock: A stock trading at a high price relative to a measure such as book value or earnings.
Market capitalization: The total market value of a company’s outstanding shares, computed as price times shares outstanding.
Discount rate: The rate of return that determines the present value of a company’s expected future cash flows.
Regression analysis: A statistical technique for estimating the strength of the relation between one variable and one or more other variables.
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