There is no universal approach to identifying value stocks or measuring their performance. Using various measures of a company’s fundamental value and picking value stocks by comparing them to sector peers would have boosted investment performance over the last decade. However, this style would still have lagged as value stocks kept getting cheaper and expensive stocks dearer.
Value stocks trade at prices below their fundamental value. If prices of all stocks converge towards their fundamental values, it is reasonable to expect value stocks to outperform their more expensive peers over time, at least on average.
Indeed, studies have shown that prices of value stocks that trade at larger discounts relative to future earnings, cash flows or book value tend to outperform significantly peers that trade at the larger premium.
This outperformance, known as the value premium, has not been observed since 2007.
In fact, the MSCI World Value index has been underperforming the MSCI Growth index since 2007, indicating that value stocks have been out of favour for some time.
Taking a HML (high-minus-low) factor strategy, which relies on only one factor of fundamental value – book equity to price – we see a similar result: the performance of value against expensive stocks has been poor for the last 14 years.
Diversified and sector neutral approaches fared significantly better
In our recent paper “Equity factor investing: “Historical perspective of recent performances”, we highlight a different approach. We use multiple dimensions (measures) of fundamental value and underscore the importance of comparing stocks with their sector peers when separating value from expensive stocks.
Comparing to sector peers is an important feature for value strategies because fair values of prices relative to fundamental values for stocks in different sectors do not necessarily compare.
For example, in fast-growing sectors such as information technology, it makes sense to expect higher prices relative to fundamental values simply because the latter tend to grow faster than for stocks in other sectors.
Sector neutrality reduces the exposure to the macroeconomic cycle. It ensures that stocks with cyclical earnings and cash flows are compared with each other only. Finally, while some claim that intangibles should play a greater role in the definition of fundamental value, this argument loses ground when we compare companies to their sector peers.
Exhibit 1 shows the performance of our proxy for the performance of value stocks against expensive stocks. In our approach, we avoid both sector biases and exposure to market risk (beta). Here, value stocks did well at least until 2018 with a far better long-term risk-adjusted performance than non-sector neutral approaches. Nevertheless, even our more robust approach did poorly since late 2018.
Exhibit 1: Cumulated monthly performance of three different approaches to constructing unconstrained long-short value portfolios – graph shows USD net returns for monthly rebalanced portfolios targeting 2.5% ex-ante volatility.
Note: No transaction costs. MSCI World universe since 2000 and reconstructed proxy of the MSCI World universe based on the largest worldwide capitalisations before. Source: Bloomberg, FactSet, Worldscope, IBES, Exshare-ICE, BNP Paribas Asset Management. For illustration purposes only.
When do value stocks underperform?
Non-sector neutral value approaches can fail because of sector bias. The main reason why the two approaches considered here did so poorly since 2007 is their sector exposure.
What about the underperformance of our sector neutral value strategy in 1998-2000 and since 2018? In fact, value stocks should underperform if stock prices diverge from their fundamental values instead of converging. This can happen, for example, when many investors make wrong assumptions about the fundamental values of companies.
It is easy to see if that is the case. It happens when the gap between the valuations of value stocks and those of their expensive peers, i.e. the value spread, expands. Value stocks become cheaper and cheaper, while their expensive peers keep getting dearer.
Such periods of value spread expansion can be painful for value investors, but tend to be followed by spread contraction and a strong outperformance of value stocks. Eventually, investors acknowledge that prices should not be that far removed from actual fundamental values and the value premium comes back in force.
Capitulation or opportunity?
As we shall see in upcoming posts, the underperformance of value stocks against expensive stocks since 2018 was accompanied by the strongest expansion of value spreads since 1998-2000.
In our next post, we will show that stock prices are now as far removed from fundamental values as they were at the peak of the tech bubble in 2000. We do not see much room for this trend to continue. It is sensible to expect prices of all stocks to converge towards fundamental values. In the coming years, this should allow value stocks to outperform significantly.