On the surface, value investing seems simple: it’s about choosing stocks that are trading for less than their “intrinsic” or true value. After all, who wouldn’t agree to a deal where one pays less than the market price? Bargains are good! That’s why Value has become one of the most popular philosophical approaches to active equity investing.
Born in the 1920s from Benjamin Graham and David Dodd’s teachings at Columbia Business School, the Value premium over the long term has been extensively documented. In the short run, the efficacy of the Value theme experiences cyclicality—like any investment. Viewed through a shorter-term lens, we’re currently at a relatively low point in the Value-performance cycle. Recent performance of new-economy growth companies, which trade on increasingly large multiples of their trailing or estimated forward earnings, has led to underperformance of many Value strategies since the end of 2016.
With that backdrop in mind, in this commentary, we’ll investigate some of the questions that reasonable investors might be asking themselves about Value right now. Does Value investing still make sense? If so, how can investors make the most of the Value theme through this down cycle in pursuit of their longer-term objectives?
Assessing Value over the long term
Using a systematic approach to valuation, we can develop a broad view on how Value as a theme has worked over time.
In their three-factor model, Eugene Fama and Ken French defined Value using three key metrics or “sub-factors”: the book to market ratio, cash flow to price ratio, and earnings to price ratio. Drawing on the Ken French Data Library’s extensive data on equity returns dating back to June 1926 (for book to market) and to June 1951 (for cash flow to price and earnings to price), we calculated compounded annual returns for each sub-factor, measured by equal-weighted quintile spreads:
(See also Figure 2.) This analysis confirms that the Value theme has yielded a distinct premium over time.
Of course, long-term efficacy and short-term performance are not the same thing. As with any investment, the Value theme has experienced cyclicality at various points in time. We’re currently at a relatively low point in the cycle.
As we can see in Figure 3, Value has been underperforming its long-term average returns for nearly eight years now. This is not the first time this has occurred. In the aftermath of World War II — when the market was returning about 20% per year — Value experienced a similar downturn, consistently registering below-average performance for almost 17 years, from 1953 to 1970. (We’ve focused here on the book-to-market sub-factor because it’s been measured since 1926, allowing us to make our observations over a longer period.)
We expect the current cycle to reverse in less time compared with the post-War downturn. Following the Global Financial Crisis, central banks in developed regions pursued aggressive monetary easing tactics to provide liquidity. This, in turn, inflated asset prices to the levels we’re now observing in the second-longest equities bull market in history. The US central bank is now actively reducing its balance sheet and increasing rates. Other central banks are likely to follow.
Rising rates have a positive effect on the Value premium. Since a large component of growth stocks’ valuation depends on the present value of future cash flows, steadily rising rates lead to progressively lower growth-stock valuations. In contrast, Value stocks are less susceptible to increasing rates, so a rising interest-rate environment would help to bring the Value premium back to long-term averages.
With this in mind, rather than abandon the Value theme until its performance improves, we believe that this is exactly the time to adhere firmly to the time-tested principles of Value investing — and not to give into irrational exuberance. At the same time, it’s important to be discerning when investing in Value, with a focus not only on minimizing downside risk, but also on positioning well to take advantage of the cyclical upturn.
Making the most of Value investing at a low point in the cycle
Defining and measuring Value.
In order to take full advantage of the Value theme, it’s important to define Value using a more comprehensive set of value-related measurements.
When we broaden the investable universe and the definition of Value beyond the conventional three-sub-factor model we’ve referred to so far, we discover some interesting trends. In Figure 4, we have used a number of well-known Value ratios to create equally weighted long-short portfolios, long the best quintile of companies on each metric, and short the worst quintile. Interestingly, although all ratios have historically experienced strong long-term returns, recent performance indicates an increasing dispersion in performance. Ratios such as dividend yield and price to cash flow have generated negative returns recently, while price to earnings (both forward and trailing) and price to sales are still providing a positive premium. (The “average” documented in Figure 4 is a simple average of the performance of each of the seven metrics over each time period.)
Using a robust definition of Value, rather than relying on one or two individual measures, can help investors to fully capture the Value premium — especially at a time when some individual definitions of value exhibit little to negative correlation.
Applying our broad definition of value in the form of a simple average of all seven metrics cited in Figure 4 reveals where Value investing opportunities may be found by sector.
Examining the performance of an average of our seven value metrics by GICS 2 sector, we see negatively correlated performance from December 2016 to May 2018.Contrary to popular belief, however, there are sectors such as energy and materials where Value investors are generating meaningful excess returns by using a broad measure of value. (See Figure 5.)
The performance of the Value theme since December 2016 has been markedly different across sectors. Value has continued to work within the Real Estate and resources sectors. In the technology and consumer segments, we have seen a meaningful decline in the efficacy of the Value theme, driven by the outperformance of the most expensive tech and consumer stocks, including the FANGs 3.
At the regional level, comparing the average annual spread returns over the long term (from December 1997 to May 2018) with recent performance (December 2016 to May 2018) for our composite factor reveals a sharp reversal in performance of Value since late 2016 in most regions, with the notable exception of Europe. (See Figure 6.)
This difference might be explained somewhat by the sector concentration in each market. Japan and the United States both have a high weight to technology and consumer discretionary stocks, where value strategies have performed least well. In contrast, Europe has a much smaller weight to technology compared with Japan and the US. Even so, this analysis shows that Value-minded investors can find pockets of relatively strong Value performance, even at this point in the cycle.
The bottom line
The Value theme is a time-tested approach to equity investing, which has yielded impressive long-term results that few investors can afford to ignore. Like any investment, Value is subject to cyclicality. During down periods in the cycle, investors can improve their long-term prospects for success by being discerning as they continue to invest in Value stocks.
To that end, we believe that a robust and multi-dimensional approach to Value is essential for investors who seek to reap the benefits of Value investing over the long term. Over the years, our research in Active Quantitative Equity has yielded an ever-more comprehensive and nuanced approach to equity valuation by market segment and business type. These nuances run broad and deep, from making adjustments for research and development expenditure in research-intensive industries, to taking into account the importance of dividend yield for Australian equities, to considering capital management by companies in the form of share buybacks. These nuances can make a meaningful difference to the performance of broad Value strategies over time.
 The metrics referenced in this analysis are: dividend yield; price-to-cash flow ratio (“P/CF”); enterprise-value-to-EBITDA (earnings before interest, taxes, depreciation, and amortization) ratio (“EV/EBITDA”); price-to-book ratio; price-to-earnings ratio (“P/E”); price-to-forward-earnings ratio (“P/FE”); and price-to-sales ratio (“P/Sales”).
2 Global Industry Classification Standard
3 Facebook, Amazon, Netflix and Alphabet’s Google. This information should not be considered a recommendation to invest in a particular sector or to buy or sell any security shown. It is not known whether the sectors or securities shown will be profitable in the future.
Book-to-Market: The inverse of the price-to-book ratio.
Cash-flow-to-Price: The inverse of the price-to-cash-flow ratio.
Dividend Yield: Measures the annual return from owning a stock.
Earnings-to-Price: The inverse of the price-to-earnings ratio.
EV/EBITDA: A popular valuation multiple used to measure the value of a company. It is the most widely used valuation multiple based on enterprise value and is often used in conjunction with, or as an alternative to, the P/E ratio to determine a company’s fair market value.
MSCI ACWI Index: An index designed to track large and mid-cap equities across 23 Developed Market and 24 Emerging Market countries.
Price-to-Book: A valuation metric that compares a company’s current share price against its book value, or the value of all its assets minus intangible assets and liabilities.
Price-to-Cash Flow: A stock valuation measure calculated by dividing a firm’s cash flow per share into its current share price. Financial analysts often prefer to value stocks using cash flow rather than earnings because earnings are more easily manipulated.
Price-to-Equity: A valuation metric that uses the ratio of the company’s current stock price versus its earnings per share.
Price-to-Forward-Earnings: A valuation metric that uses the ratio of the company’s current stock price versus its forecasted earnings per share.
Price-to-Sales: A valuation metric for stocks calculated by dividing the company’s market cap by the revenue in the most recent year or, equivalently, divide the per-share stock price by the per-share revenue.
The views expressed in this material are the views of Olivia Engel through the period ended June 30, 2018 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
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