Will disciplined value investing be rewarded long term? Larry Swedroe on the evidence, and current stock valuations.
Having a well-thought-out investment plan is the necessary condition for successful investing. However, it’s not sufficient.
The sufficient condition is having the discipline to stay the course during the virtually inevitable periods when a strategy underperforms. That, of course, is why Warren Buffett once advised investors that “the most important quality for an investor is temperament, not intellect.”
Unfortunately, it’s my experience that, when contemplating investment returns, the typical investor considers three years a long time, five years a very long time and 10 years an eternity. However, financial economists know that when it comes to the returns of risky assets, periods as short as three or five years, or even 10 years, should be considered nothing more than noise.
No more proof is required than the fact that over the nine years ending in 2008, the S&P 500 Index underperformed riskless one-month Treasuries by a compound 6.7% a year, a cumulative underperformance of 59%. It underperformed five-year Treasuries by 10.8% a year, a cumulative underperformance of 115%.
Factors Hold Up
Investors in stocks should not have lost faith in their belief that stocks should outperform safer Treasuries due to that experience. And most didn’t.
Yet when small stocks, or value stocks, underperform for a few years, as value stocks did from 2008 through 2015 (they underperformed growth stocks by 2% a year, or a cumulative 16%), they begin to question their diversification strategy and lose discipline.
Value’s extended period of poor performance has led many to question whether the publication of academic research on its premium, along with the strategy’s ensuing popularity, brought about cash flows which may, in turn, have resulted in the premium being arbitraged away.
To test this hypothesis, David Blitz, author of the February 2017 paper “Are Exchange-Traded Funds Harvesting Factor Premiums?”, analyzed the factor exposures of ETFs and found that “for each factor there are not only funds which offer a large positive exposure, but also funds which offer a large negative exposure towards that factor.”
He also found that “on aggregate, all factor exposures turn out to be close to zero [ranging from -0.03 to 0.03], and plain market exposure is all that remains.”
Blitz writes: “This finding argues against the notion that factor premiums are rapidly being arbitraged away by ETF investors and also against the related concern that factor strategies are becoming ‘overcrowded trades.’”
Sophisticated investors know that, over the long term, equity returns tend to exhibit mean reversion. This occurs because periods of poor (strong) performance typically end with valuations at lower (higher) levels, forecasting higher (lower) forward-looking return expectations.
With that in mind, I will examine the current valuations of U.S. value stocks, specifically their P/E and BtM ratios, to see if they are relatively cheap (which research has found predicts a higher value premium in the future) or relatively expensive (which predicts a low or nonexistent premium going forward).
To determine if value is now relatively expensive or relatively cheap, I’ll compare today’s valuations with those from 1994 (before the growth bubble began later in the 1990s).
But first, the value premium was 5.5% from 1927 through 1994. It turned highly negative (with a -19% cumulative return) from 1995 through the first quarter of 2000. The high valuations of growth stocks in March 2000 led to value’s best historical performance over the next seven years, with an annual premium in excess of 15%.
At the end of 1994, the BtM ratio of U.S. large growth stocks was 0.4 and the BtM ratio of U.S. large value stocks was 0.85. Thus, from a BtM perspective, large growth stocks were 2.12 times as expensive as large value stocks.
The P/E ratios were 15.8 for large growth stocks and 10.3 for large value stocks. Thus, from a P/E perspective, large growth stocks were trading 1.53 times as expensively as large value stocks.
At the end of 1994, the BtM ratio of U.S. small stocks (the data I had available defined small stocks as CRSP deciles 9-10, or what would be considered microcaps) was 0.61, and the BtM ratio of U.S. small value stocks (with small stocks in this case defined as CRSP deciles 6-10) was 0.93.
Thus, from a BtM perspective, small stocks were trading 1.52 times as expensively as small value stocks. The P/E ratios were 14.1 for small stocks (CRSP deciles 9-10) and 11.7 for small value stocks (again with small stocks defined as CRSP deciles 6-10). Thus, from a P/E perspective, small stocks were trading 1.21 times as expensively as small value stocks.
A DFA Comparison
I’ll use funds from Dimensional Fund Advisors (DFA) to compare today’s valuations, because they use academic definitions for asset classes. (Full disclosure: My firm, Buckingham Strategic Wealth, recommends DFA funds in constructing client portfolios.)
I’ll use DFA’s U.S. Large Cap Value Fund (DFLVX) for large value, DFA’s U.S. Small Cap Value Fund (DFSVX) for small value and DFA’s U.S. Micro Cap Fund (DFSCX) for small-cap equities (I don’t have data for a small growth index). For U.S. large growth stocks, I’ll use the iShares Russell 1000 Growth ETF (IWF).
As of Aug. 31, 2017, the BtM ratio of U.S. large growth stocks was 0.16, and the BtM ratio of U.S. large value stocks was 0.56. Thus, from a BtM perspective, large growth stocks were 3.5 times as expensive as large value stocks (versus 2.12 times as expensive at the end of 1994).
The P/E ratios were 24.1 for large growth stocks and 16.4 for large value stocks. Thus, from a P/E perspective, large growth stocks were trading 1.47 times as expensively as large value stocks (versus 1.53 times as expensively at the end of 1994). For large stocks, at least by the BtM metric, value is trading much cheaper than it was at the end of 1994.
Now I’ll look at U.S. small stocks. As of Aug. 31, 2017, the BtM ratio of DFSCX was 0.54 and the BtM ratio of DFSVX was 0.83. Thus, from a BtM perspective, small stocks were trading 1.54 times as expensively as small value stocks, virtually identical to the 1.52 ratio that existed at the end of 1994.
The P/E ratios were 20.4 for small stocks (CRSP deciles 9-10) and 17.8 for small value stocks (with small stocks being CRSP deciles 6-10). Thus, from a P/E perspective, U.S. small stocks were trading 1.15 times as expensively as small value stocks, not much different than the 1.21 ratio that existed at the end of 1994.
The bottom line is that, relative to growth stocks, value stocks are trading at similar—if not cheaper—valuations than they were in 1994. In other words, because valuations are the best predictor of future returns we have, the evidence suggests that the publication of research on the value premium, and the popularity of value strategies, has not led to the decline in the expected value premium.
The poor performance of value stocks over the period from 2008 through 2015 has restored valuations to levels that are at least as inexpensive as had prevailed before the tech bubble began.
This evidence should bolster investors’ confidence in the likelihood of a value premium going forward. With that said, there are no guarantees. Research shows that the value premium depends not only on relative valuations, but on economic conditions.
Effects Of Economic Conditions
For example, Cathy Xuying Cao, Chongyang Chen and Vinay Datar, authors of the study “Value Effect and Macroeconomic Risk,” which appears in the Fall 2017 issue of The Journal of Investing, found that returns from value and growth strategies are sensitive to the changes in macroeconomic conditions.
The authors, for instance, found that value stocks have higher sensitivities than growth stocks to certain macroeconomic factors, specifically the growth rate of industrial production, the term spread, the default premium and unexpected inflation. The risk loadings of high BtM and low P/E firms are substantially larger (and statistically significant) than the loadings of low BtM firms with respect to each of these macroeconomic factors.
In addition, the value premium changes with economic conditions and value strategies tend to underperform growth strategies during NBER-defined recession periods.
Because there are no clear crystal balls, investing is about putting the odds in your favor. And both the evidence and current valuations provide support for the premise that, over the long term, value investors are likely to be rewarded for their discipline.
This commentary originally appeared October 9 on ETF.com
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