By LARRY SWEDROE
As the chief research officer of Buckingham Wealth Partners, I have been getting lots of questions from investors concerned about the dramatic outperformance over the past decade of growth stocks versus value stocks; the historically low level of interest rates and the risk of rising inflation; and historically high P/E ratios. As always, when answering such questions, we look to the academic research. We will begin by discussing the performance of the value factor.
The value factor
As I explained in a recent article for The Evidence Based Investor, the dramatic underperformance of value stocks from 2017 to 2020 was not caused by a change in the economic regime to one in which the growth of earnings for growth stocks would far outpace the growth of earnings for value stocks. Instead, it was caused by a dramatic widening of the valuation spread between growth and value stocks to levels not seen since the tech bubble of the late 1990s—growth stocks became much more expensive relative to value stocks. Importantly, the research (such as the March 2019 study Strategies Can Be Expensive Too! The Value Spread and Asset Allocation in Global Equity Markets) demonstrates that valuation spreads do inform future returns — wider spreads predict greater premiums in the future.
With that in mind, in their September 2021 paper, Robeco’s research team noted that while value has outperformed since October 2020 (from October 2020 to August 2021, the U.S. Fama-French value index returned a cumulative 65 percent, outperforming the U.S. Fama-French growth index by 30 percentage points), the valuation spread had actually reached new highs due to improvements in the operating performance of the value companies—on average, value stocks displayed gross profitability levels that were more than 3 percent higher than their growth counterparts at the end of August 2021. They added: “Earnings expectations, as proxied by analyst earnings per share (EPS) revisions, for value stocks versus those of their growth peers have also improved since the end of 2020.” They concluded that, relative to historical levels, “value stocks currently trade at very cheap levels and growth stocks at very expensive levels.” In fact, based on 35 years of data, at the end of August the spread was at the 100th percentile and was almost 5 standard deviations above the historical mean.
Robeco noted that the recent outperformance of value stocks has meant not only that they have momentum in their favor, but it has also impacted the valuations of the momentum factor.
The momentum factor
As momentum strategies have become significantly tilted toward cheaper (value) stocks, the momentum factor is now also trading at historically attractive valuations. The valuation spread for momentum stocks was at the 91st percentile and was 1.2 standard deviations from its historical average. That value stocks now have the momentum factor working in their favor is important because the research, including the 2018 studies Factor Momentum Everywhere and Is there Momentum in Factor Premia? Evidence from International Equity Markets, and the 2019 study Factor Momentum and the Momentum Factor, has found that momentum is explained by factor momentum.
Robeco also examined the relative valuations of two other factors: low risk and quality.
The low risk and quality factors
Robeco found that both the low risk and quality factors have also become more attractively valued. The valuation spread for quality was in the 97th percentile versus its own history and more than 3 standard deviations from its long-term average. The valuation spread for low risk was also at the 97th percentile and was almost 2 standard deviations from its historical average.
Robeco’s findings led them to conclude: “All four factors are currently attractively priced from a fundamental point of view, i.e. they currently trade at lower valuations compared to their history.” For investors using multifactor strategies, Robeco noted that the composite value spread for the four factors was in the 99th percentile at the end of August 2021 and significantly above its long-term average to the tune of 5.5 standard deviations. Robeco also highlighted the diversification benefits of a multifactor strategy, noting: “Despite the attractive valuations of all four factors, the correlations between them remain relatively low.”
We now turn to the relationship between interest rates and the value factor.
The value factor and interest rates
Many have tried to explain the underperformance of value stocks by pointing to the fact that growth stocks are longer-duration assets which should, in theory, benefit from the falling interest rates we experienced during the COVID-19 crisis. Unfortunately, the research, including Thomas Maloney and Tobias Moskowitz’s May 2020 study Value and Interest Rates: Are Rates to Blame for Value’s Torments? has found that over the long term there has been no strong correlation between either the level of interest rates or the shape of the curve and the value premium.
As further support of the failure of interest rate changes explaining value’s underperformance, Robeco’s paper pointed out that the U.S. has been a declining interest rate regime for 40 years, and value performed well over most of that period. In addition, value’s performance has been particularly strong in Japan, which has experienced declining and low rates for the last 30 years.
Robeco also examined the relationship between interest rates and the other three factors: low risk, momentum and quality. They concluded: “Yield changes told us little about future factor premiums.” The conclusion you should draw is that even if you could forecast interest rates well, that would not provide you with meaningful information in terms of factor timing. They added: “Moreover, the pervasive low-yield environment of the last few decades does not tell us a lot about the return prospects of factor premiums.”
We can also review the findings of the 2018 study What Happens to Stocks when Interest Rates Rise? in which Andrew Berkin examined the relationship between interest rates and various factors. He found that stocks have had a wide range of returns, both positive and negative, during times of rising rates. He also found that for most factors, including value (as defined by the metric HML, the return of stocks with high book-to-market ratios minus the return of stocks with low book-to-market ratios), there was no distinguishing pattern when looking at interest rates in a variety of ways (such as long term, short term, spread, level and change). The main exception was the dividend yield, which tends to do well in the same year that rates fall (and vice versa when they rise), a simple explanation being that investors are reaching for yield. However, results are reversed the following year: High (low) dividend yield stocks do relatively poorly (well) in the year after rates fall.
We now turn to addressing the issue of historically high P/E ratios.
High valuations
While it is true that the U.S. large growth stocks that dominate U.S. market cap-weighted indices like the S&P 500 are currently trading at historically high P/E ratios (as of October 7, 2021, the P/E of the iShares Russell 1000 Growth ETF (IWF) was 27.5) because of their relatively poor performance over the last decade, value asset classes are trading at much lower valuations. For example, Bridgeway’s Omni Small-Cap Value Fund (BOSVX) has a P/E of just 10, Dimensional’s International Small-Cap Value Fund (DISVX) has a P/E of just 9.5, and their Emerging Markets Value Fund (DFEVX) has a P/E of just 7.9. In other words, not everything is expensive—there are asset classes with relatively low valuations and thus large risk premiums.
With that said, it’s important to not make the mistake of thinking that assets trading at lower valuations are better investments. Instead, you should recognize that the lower valuations reflect the market’s view that these are riskier assets and thus are priced to reflect that greater risk, which is accompanied by a risk premium to compensate investors for accepting that incremental risk. In other words, lower valuations do provide information in the form of higher expected (but not guaranteed) returns.
Investor takeaways
The research demonstrates that the prudent strategy is to have exposure to multiple factors in a portfolio. Doing so diversifies individual factor and stock risks (all risk strategies go through long periods of underperformance, making diversification your friend). It also diversifies factor sensitivities to yield movements because these vary widely across factors and time. However, diversification is only a necessary condition for prudent investing. The sufficient condition is to have the discipline to stay the course, ignoring the “noise of the market” and rebalancing along the way in order to maintain your well-thought-out asset allocation strategy.
For value investors, the findings also provide good news in that not only is value trading at about the cheapest level in history, the underlying fundamentals (earnings) are also improving for value stocks relative to growth stocks. As Robeco noted in their conclusion: “Currently, value stocks are more profitable and have better analyst revisions than their growth peers.”
For informational and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is based upon third party data which may become outdated or otherwise superseded without notice. Third party information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party websites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them. The opinions expressed by featured authors are their own and may not accurately reflect those of the Buckingham Strategic Wealth® and Buckingham Strategic Partners®, collectively Buckingham Wealth Partners. Neither the Securities and Exchange Commission (SEC) nor any state or federal agency has approved, confirmed the accuracy, or determined the adequacy of this article. LSR-21-16
LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of numerous books on investing.
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