Equities | Investment Manager Research
Down…But Not Out, There’s Still Hope for Value
• Over the last decade, value stocks trailed their growth peers by a significant margin, and in 2020, that margin has only widened.
• Despite poor performance, we believe the value premium will turn positive at some point in the future. Value has sustained elongated periods of underperformance in the past, but over longer periods, it has generated a positive premium.
• Value stocks continue to have attractive valuations relative to growth stocks on a historical basis. Despite a significant sell-off in 2020, growth stocks continue to look expensive relative to their history.
• Given the unpredictability of the value premium, investors should maintain a diversified portfolio containing both value and growth stocks. Over the long term, we expect this approach will generate superior risk-adjusted returns.
In our prior paper, Is Value Dead?, we noted that growth stocks outperformed value stocks over the last decade. While value has endured periods of both underperformance and outperformance relative to growth in the past, the magnitude and duration of value’s most recent struggle has been nothing short of unprecedented. Unfortunately, for value investors, this trend not only persisted but actually accelerated in 2020.
Exhibit 1 below depicts the calendar year value premium – defined henceforth as the excess return of the Russell 3000 Value Index over the Russell 3000 Growth Index – every year since 1986. The table displays the average calendar year value premium for various periods of time.
Through four months of 2020, value underperformed growth by 17.2 percentage points, which represents the worst year for value outside of 1999, the height of the dotcom bubble.
If we evaluate the value premium over longer periods, we observe similar results. In fact, value’s struggles become even more pronounced. Exhibit 2 below depicts the trailing three-year annualized value premium on a quarterly basis over the past 10 years. During the most recent period ending on March 31, 2020, value underperformed growth by 11.9 percentage points per year, which represents the worst rolling three-year period on a quarterly basis in a decade.
Given the underperformance of value, investors are justifiably questioning whether they should continue to allocate to value stocks. We cannot say with certainty that value will return to favor, but we see no fundamental reason to believe the value philosophy has become permanently impaired. In addition, while history does not necessarily repeat itself, it often serves as a good compass, and historically, value experienced sustained periods of both outperformance and underperformance when compared to growth. It is also worth noting that value stocks are cheaper relative to growth stocks than at almost any point in their history, which has lent itself to attractive buying opportunities in the past.
Exhibit 3 plots the relative value and relative growth forward P/E ratios of the Russell 3000 – calculated as the forward P/E ratio of the Russell 3000 Value Index divided by the forward P/E ratio of the Russell 3000 Index and the forward P/E ratio of the Russell 3000 Growth Index divided by the forward P/E ratio of the Russell 3000 Index, respectively. The relative value forward P/E ratio currently registers at 0.83x, or 1.45 standard deviations below its historical mean. This implies value looks cheap based on its historical valuation relative to core.
In contrast, the relative growth forward P/E is 1.19x, or 0.61 standard deviations above its historical mean. Even after a significant sell-off in the first quarter of 2020, growth stocks look expensive based on their historical valuation relative to core.
As Exhibit 3 shows, the spread in valuations between value and growth stocks is near record highs. In the past, this coincided with a positive value premium over the next 12 months. Exhibit 4 displays the relative growth to value forward P/E ratio – defined as the relative growth forward P/E ratio divided by the relative value forward P/E ratio – in relation to its history and compares it with the value premium over the next 12 months. As expected, when value looks cheaper relative to growth, the forward-looking value premium tends to be larger. Alternatively, when value stocks are more expensive relative to growth stocks, the forward-looking value premium tends to be negative. The relative growth to value forward P/E ratio is currently 1.43, or 1.01 standard deviations above its historical mean, which indicates attractive relative valuations for value stocks.
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