Value stocks have been underperforming ‘glamour stocks’ for a while, rendering valuations as cheap as they were in the tech bubble of 2000, while ‘glamour stocks’ are as expensive as back then. This is the case globally, regionally and across macro-sectors. Prices of value and ‘glamour’ stocks have simply moved by much more than any changes in their fundamental values. A compression of so-called value spreads is now the most likely scenario. That is good news for value investors for the coming years.
Value stocks are cheap relative to their fundamental values, while glamour stocks are highly priced, creating gaps in valuations known as value spreads. The value premium is the expected outperformance that arises as value stocks and ‘glamour’ stocks converge towards their respective fundamental values. Accordingly, a larger spread signals a larger opportunity for value investors.
Value investors can earn a value premium by investing in value stocks and by selling or underweighting ‘glamour’ stocks. They then wait for the prices to converge towards the fundamental values. Once the prices have converged, the premium can be pocketed and positions be closed. Investors can then look for new opportunities.
All this works well for as long as investors acknowledge the mispricing and create the demand for value stocks that will compress value spreads as prices converge. However, value spreads can also rise at times. This typically happens when investors expect the fundamental values for value stocks to fall and those for glamour stocks to rise.
If such expectations are wrong, the value spreads widen further. While larger value spreads eventually offer a larger opportunity for value investors, spread widening can be painful as it is accompanied by the underperformance of value stocks relative to their glamour peers.
Value spreads are back at tech bubble levels across markets…
A period marked by a notably large expansion of value spreads and underperformance of value stocks was the tech bubble of the late 1990s. During the recent underperformance, spreads rose as high as they were in 2000 at the peak of the tech bubble across all regions and sectors.
Exhibit 1 shows a composite of value spreads for stocks in the MSCI World index as well as periods of spread expansion and compression. Since 2018, spreads have increased to the record levels of the tech bubble. The picture was similar in the US and Europe (exhibit 2).
…and macro sectors
The same is true in macro sectors. As shown in exhibit 3, the value spreads of sectors that could be qualified as the winners of the COVID-19 crisis, i.e. information technology & communication services and defensives (consumer staples, healthcare and utilities), are at levels similar to those seen at the peak of the tech bubble.
For the cyclical sectors such as materials and consumer discretionary, financials, energy and industrials, spreads have also reached the same extreme levels as in 2000.
We do not see much room for value spreads to continue expanding. Prices of value and ‘glamour’ stocks have diverged significantly from their fundamental values, making value stocks cheaper and ‘glamour’ stocks dearer. Any investor expectations that fundamental values did not materialise have now been discounted by much more than can be expected.
We believe that value investors are now facing one of the best opportunities to earn substantial returns since the peak of the tech bubble. Playing the convergence of stock prices towards fundamental values remains a sensible investment philosophy: convergence is the likely trend in coming years.
In our next article, we investigate the expected consequences of a compression in value spreads on the performance of various equity factor styles and their multi-factor combinations.
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