February 19, 2019
Value in Value
Please read important disclosures HERE
February 19, 2019
Please read important disclosures HERE
Stocks in U.S. and foreign markets registered strong gains at the start of the year, following the harsh sell-off in last year’s fourth quarter. The S&P 500 Index of large U.S. stocks gained 8% in January and foreign stocks, as measured by the MSCI ACWI ex USA Index, rose by a similar amount.
The rally in stocks was propelled by a major shift in the Federal Reserve’s approach to monetary policy; following the big market sell-off in December, the Fed tabled its plans for future interest rate hikes and expressed a more flexible approach to reducing its balance sheet. Stocks in the U.S. also benefited from reports showing the economy ended 2018 on firm footing. Holiday sales results came in better than expected and the Labor Department reported more than 300,000 jobs were created in December. Developments on the trade front also provided support for stocks as comments by U.S. and Chinese negotiators offered hope that a full-blown trade war could be averted.
Given these positive developments at the start of the year, it is tempting to assume that all bodes well for the stock market going forward. While we are hopeful in this regard, we need to look back only as far as last year’s first quarter to be reminded of how quickly stocks can reverse course. In January of 2018, U.S. stocks also registered strong gains, rising nearly 6%, but these gains were subsequently erased over the following two months. In the current market environment, there are plenty of potential catalysts that could darken the mood of investors, including the deadlines in March for the British to agree to Brexit terms and for the U.S. and China to agree on a trade deal. Moreover, our internal research suggests that, even after the recent market gains, the risk of a protracted bear market is higher than normal in the wake of last year’s sell-off that followed an extended period of stock price gains.
With risks elevated, we believe risk-sensitive investors and those with shorter time horizons would be prudent to be a bit more cautious. There is no “one-size-fits-all” strategy in this regard but possible strategies include modestly reducing allocations to stocks, raising cash in the near term for spending needs later in the year, and rebalancing portfolios to target equity allocations more slowly than otherwise. Importantly, even though downside risks are elevated, we believe any portfolio adjustments should be modest since the probabilities still favor stocks (stock returns, on average, have been positive in three out of four years in the past1).
Value Stocks Look Like a Good Bet
Low-priced “value” stocks have generated substantially higher returns than the overall stock market over the long-term. Considering the performance of U.S. stocks over the past 80 years, value stocks have outperformed the broad stock market by nearly 3% per year, on average.2 This is a compelling advantage that informs our strategy of maintaining an ongoing overweight to value stocks in client portfolios.
The return premium from value stocks has come at the expense of stocks at the other end of the spectrum: growth stocks. Examining relative valuations in the current market, we believe investors in value stocks are particularly well-positioned to capture a long-term value stock premium. The following graph shows how the valuation of value stocks has changed relative to growth stocks since 1995 based on the price-to-book ratio (P/B)3.
Source: Bloomberg, monthly data from January 1995 to December 2018
The graph shows the ratio of the P/B of large value stocks to the P/B of large growth stocks through time. By definition, the P/B of value stocks will be less than that of growth stocks so the ratio of the two P/Bs will always be less than one. This ratio has averaged 0.43 over the 23-year period while displaying substantial variability. At the peak of the late 1990s technology stock bubble, when growth stocks were all the rage, the ratio reached a low of 0.29, implying that value stocks were quite cheap relative to growth stocks. After the bubble burst, the ratio jumped to a high of 0.63 in 2001. In retrospect, the height of the tech bubble in 2000 was an excellent time to be overweight value stocks.
Considering the current market environment, value stocks are as cheap relative to growth stocks (and therefore the overall stock market) as they were in 2000. Of course, this doesn’t guarantee that value stocks will outperform this year or next, but the probabilities favor better returns from value stocks over the next few years.
The extra expected return from value stocks does not come without costs, however. Investors wishing to capture the long-term value premium must be willing to accept periods of underperformance that may last an uncomfortably long time and we have experienced such a period recently. One of the primary mutual funds we use to represent value stocks is the DFA US Large Cap Value Fund (DFLVX). As the following table shows, DFLVX has lagged the S&P 500 by almost 3% per year over the past five years and has basically matched the S&P 500 over the past 10 years. To see the value premium at work, we must go back even further: considering the past 20 years, DFLVX has outperformed the S&P 500 by nearly 2% per year.
Annualized Returns, Period Ending 12/31/18
|Period||DFLVX||S&P 500||DFLVX - S&P 500|
|Past 5 Years||5.83%||8.49%||-2.66%|
|Past 10 Years||13.17%||13.12%||0.05%|
|Past 20 Years||7.52%||5.62%||1.90%|
Maintaining a long-term commitment to a value stock strategy may be easier if investors own stocks within a mutual fund format rather than owning them outright. To understand why, consider the stocks owned by DFLVX as of the end of 2018. A representative sampling of the fund’s top holdings includes AT&T, Exxon Mobil, and Wells Fargo. While these are solid companies, they are not expected to be fast growers. Investors who own companies such as these outright may be tempted, upon reviewing their investments, to replace them with fast-growing companies such as Amazon and Google, particularly after periods when their value stocks have performed poorly.
Paradoxically, the very reason investors prefer growth stocks over value stocks largely explains why value stocks have outperformed over the long-term. In the past, investors have tended to bid up the prices of growth stocks to overly optimistic levels while paying too little for value stocks. On average, growth companies have fallen short of these lofty expectations while value companies have performed better than the deep pessimism reflected in their prices.
We believe the tendency to overpay for growth and underpay for value is a behavioral bias that is likely to persist in the future. Studies in behavioral finance have highlighted various innate biases that lead investors to make suboptimal investment decisions. One such bias, referred to as “recency bias,” describes the tendency for people to assume the future will look like the recent past. This recency bias likely contributes to investors’ preference for growth stocks.
Some might counter that investors will cease to exhibit this bias for growth stocks once they are aware of its existence. However, the tech bubble of the late 1990s is a counterpoint to this contention — while the value stock premium was well known within the investment community prior to the tech bubble, this knowledge did not deter investors from bidding up growth stocks to unsustainable levels.
Setting the odds in your favor is a key component of successful long-term investing, and we believe that a strategy of consistently tilting toward value stocks provides an excellent way for disciplined long-term investors to implement this concept. Moreover, given current valuation levels, we believe the odds for value stocks are particularly compelling at the present time.
1. From 1939–2018, the S&P 500 has generated positive returns 76% of the time. Source: Dimensional Fund Advisors investment returns software program, B|O|S internal research.
2. From 1939–2018, the Fama-French U.S. Large Value Index and the S&P 500 generated annualized returns of 13.36% and 10.73%, respectively. Over the same period, the Fama-French U.S. Small Value Index and the Fama-French U.S. Small Cap Index generated annualized returns of 16.25% and 12.69%, respectively. Source: Dimensional Fund Advisors investment returns software program, B|O|S internal research.
3. The price-to-book ratio (P/B) is one of the primary metrics investment analysts use to compare stock valuations. Other metrics include price-to-earnings, price-to-sales, and price-to-cash flow. P/B is calculated by dividing the market value of the company’s stock (current share price times total number of shares outstanding) by the company’s current book value (total assets minus total liabilities as recorded on the company’s books). Using this metric, stocks that have low P/Bs are considered value stocks and stocks that have high P/Bs are considered growth stocks.