All successful investment strategies experience periods of underperformance. It’s prudent at such times to examine whether something has fundamentally altered the source of a strategy’s outperformance. Often, challenging times provide tremendous opportunities for investors with the discipline and conviction to stay the course. The value premium, a reliable source of excess returns for many decades, has recently experienced a prolonged period of underperformance. Has this created an opportunity or is it different this time?
Explanation of the Value Premium
The value premium reflects the excess return investors have historically earned owning inexpensive stocks vs. expensive stocks. The value premium was first identified by Eugene Fama and Kenneth French. Fama and French highlighted the outperformance over time of stocks with High Book to Market (value) relative to those Low Book to Market (growth). From 1927 to June 2019, the value premium using this metric has been 3.1% per year and value stocks have outperformed growth 87% of the time over rolling 10-year periods. Further research has shown the value premium to be persistent over time, across geographies and economic regimes.
The persistence of the value premium has been explained with both risk-based and behavioral explanations. Value stocks tend to be lower quality businesses, often with more cyclical earnings, higher leverage and lower returns on capital. Thus, investors require a premium to own these businesses which may be more susceptible to drawdowns in difficult economic times.
Behavioral explanations focus on investors’ tendency to be overly optimistic about the prospects for high growth stocks and overpay for them. In contrast, businesses experiencing distress are often neglected by investors. A company’s stock performance is ultimately dependent on how the business performs relative to the expectations priced in by investors. When the expectations are ratcheted down for high growth stocks, the price impact can be severe. The low expectations for value stocks results in fewer disappointments.
The Demise of the Value Premium?
Prior to the current period, the value premium was last negative at the peak of the technology bubble in 1999-2000. The expansion of the internet offered the potential to transform industries and drive long-term growth. Investors ultimately priced in wildly optimistic expectations for technology stocks which failed to be met. The value premium in the decade following the peak of the technology bubble was over 4% per year.
Many of the arguments today for the demise of the value premium are comparable to those made during the technology bubble. Some suggest that a small number of disruptive companies are gaining a disproportionate share of economic profits at the expense of legacy companies. Amazon’s tremendous success and the struggles of the retail sector are a primary example. Facebook, Amazon, Google and Apple have developed dominant franchises which have benefited from internet penetration. Time will tell if their competitive positions are more sustainable than some of the largest companies at the top of the technology bubble. Of the top 10 holdings in the S&P 500 in 1999, only three currently trade with a higher market value today, twenty years later.
Growth stocks do typically grow earnings faster than value stocks, though often not fast enough to meet expectations. Growth outperformance does not appear to be justified by a widening in the earnings growth rates between growth and value stocks. In fact, earnings growth for the Russell 1000 Value has exceeded the Russell 1000 Growth over the past 10 years, though coming off a cyclical trough.
An important long-term driver of the value premium has been the significant underperformance of unprofitable growth stocks, particularly in the small cap market. Dimensional Fund Advisors (DFA) tracks an index of small cap growth businesses with low profitability. From 1975 to June of 2019, the DFA US Small Growth/Low Profit index has underperformed the broader small cap market by 9% per year. Since the start of 2017, these unprofitable small cap growth businesses have returned 23% per year vs. 5% per annum for the small cap index. The only prior time this speculative group outperformed to this degree was during the technology bubble. History would suggest this is not sustainable.
The broader universe of growth stocks has seen a meaningful increase in valuation over the last several years. While value stocks have also benefited from rising valuations, their discount relative to growth is at levels only approached during the technology bubble. Once again, investors are pricing in material fundamental outperformance for growth stocks relative to value. If these optimistic expectations are not realized, value stocks will again outperform.
Sir John Templeton famously stated, “The four most dangerous words in investing are: ‘it’s different this time.’” We believe this is appropriate advice when considering the value premium. The persistence of the value premium over time, and across markets, and the strong fundamental basis for its existence lead us to conclude that recent underperformance provides an opportunity.
The above commentary represents the opinions of the author as of 8.26.19 and are subject to change at any time due to market or economic conditions or other factors. The information above is for educational and illustrative purposes only and does not constitute investment, tax or legal advice.