TL;DR: Value stocks are calling out for your attention. The value spread is at historically favorable levels (for value stocks), and this predicts strong future earnings relative to growth.
Not since the Dot Com era have we seen value stocks spreading themselves so enticingly.
What is the value spread? Definitions abound, but in general, it measures the relative cheapness of value stocks to growth stocks. For example, one might compare the E/P of value stocks to E/P of growth stocks (the inverse of the P/E ratio). More complex frameworks include metrics such as book/price, forecasted earnings to price, etc.
But value stocks are cheap for a reason, you say. The literature comes to the rescue: there have been numerous empirical studies verifying that periods of outperformance follow relatively cheap periods. Much as heightened values of the Shiller P/E ratio tends to forecast poor returns, historically cheap value stocks forecast great returns. This phenomenon is pronounced for small cap value.
In fact, simple mean reversion implies large premiums:
Value stocks look like a heck of a value right now! Look at it this way. As of yesterday, value stocks have a forward P/E of 13.4, against growth stocks at 22.4. The ratio is 0.57. To get back to the historical average ratio of 0.75, and assuming stable earnings, value stocks would have to rise by about 30 per cent, or growth stocks would have to fall by over 20 per cent, or some combination of both. A little mean reversion here would mean a lot of outperformance for value.
Let's now present some graphs. From AQR capital, a normalized value spread measure the last few decades: graph. Here higher is cheaper value. They use a complex mixture to compute valuation, described in their blog posts.
From the FT, a simpler graph of price/earnings: graph. Note that here 'lower' is cheaper since they use P/E instead of E/P.
This phenomenon is robust across the world: graph. In fact, the cheapness is even more extreme than Europe: graph. An FT article explains just how remarkable this is:
Arnold also writes “value stocks in Europe are currently trading on lower PEs than they were five years ago . . . there are very few, if any, parts of developed market equities that the market is so pessimistic about that they’ve actually de-rated over the last five years.”
On top of the gap between the valuation of European growth and value, there is the gap between US value and European value: “The Russell 1000 value index is a 16.5 forward PE, while the equivalent in Europe is on 11, an enormous differential in its own right. A cheap stock in the US is held in much higher regard than a cheap stock in Europe. Value stocks in Europe are the unloved of the unloved!”
Finally, Arnold writes that “over the last five years Europe’s cheapest companies have delivered more profit growth than their growth counterparts . . . so over that 5 year period the real growth stocks in Europe, in terms of fundamentals anyway, have been the value stocks!”
Growth has been impressive the past decade, as Larry Swedroe writes:
While it is true that earnings of large growth stocks have grown faster than earnings of small-cap value stocks — Avantis estimated that large growth earnings grew by approximately 194 percent between January 2010 and July 2021 versus an earnings increase of 177 percent for small value stocks — the differential was less than 2 percent per year. That differential is a lot smaller than what would have been the expected differential, and certainly cannot explain the fact that the return to large growth stocks was 492 percent versus the 181 percent return to small value stocks over that same period.
Swedroe gives a short literature review on the evidence that this spread predicts returns. For example,
Adam Zaremba and Mehmet Umutlu, authors of the March 2019 study Strategies Can Be Expensive Too! The Value Spread and Asset Allocation in Global Equity Markets, examined whether the value spread (the difference in valuation ratios between the long and the short sides of the trade) was useful for forecasting returns on quantitative equity strategies for country selection. To test this, they examined a sample of 120 country-level equity strategies replicated within 72 stock markets for the years 1996 through 2017.
They found: “The breadth of the value spread can predict the future returns in the cross-section. We show that equity strategies with a wide value spread markedly outperform strategies with a narrow value spread. In other words, if you wonder which strategy might produce decent payoffs in the future, pay attention to the value spread.”
Mean reversion alone predicts strong outperformance, but it is comforting to have empirical evidence across the world verifying that this mean reversion will probably happen.
This cheapness won't last forever, if history is to repeat itself. Eventually, money will flows into such unappreciated value, with strong fundamentals. The time to sin a little and market time is now. Thus, I conclude with a recommendation to buy small cap value ETFs, where the premiums are even higher.
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