The Renaissance of Value?

27 Jun 2016

Key takeaways

  • While investors have long argued over many anomalies in equity markets, no anomaly has generated as much interest (or controversy) as the value premium, or the finding that over the long run, value stocks outperform growth stocks.
  • The truth probably lies between these two extremes, though I lean toward the first group because I have seen convincing evidence that earnings for value companies do implode in recessions, and recover correspondingly sharply in recoveries.
  • Going forward, I expect value to outperform growth. Since mid-February, as energy and mineral prices have risen, value has outperformed growth in the U.S. and has performed in line with growth in Europe and in emerging markets, though there has been a very sharp two day reversal in Europe in the wake of the Brexit referendum.

Full commentary

While FFTW focuses primarily on fixed income, we find it interesting to take an occasional look at equity markets on account of the significant linkages between the two markets. This piece focuses on the equity market.

While investors have long argued over many anomalies in equity markets, no anomaly has generated as much interest (or controversy) as the value premium, or the finding that over the long run, value stocks outperform growth stocks. Both the source and the magnitude of this outperformance have been hotly debated, with most debaters falling into one of two camps. Those who believe that the higher return of value stocks are compensation for some unseen risk (perhaps they carry with them some tail risk that materializes when the economy hits a particularly bad patch, as it did in 2008), and those who believe that the higher return of value stocks are a reflection of human frailties, and accrues on account of systematic biases in investors’ behavior. We might call the first camp the Fama-French camp1, and the second the Lakonishok camp2.

The truth probably lies between these two extremes, though I must confess that I lean toward the first group because I have seen convincing evidence that earnings for value companies do implode in recessions, and recover correspondingly sharply in recoveries. In fact, it can be shown3 mathematically that over the very long term, growth and value indices must experience the same rate of per-share earnings growth, and hence the same price return. Any difference in total return is driven entirely by the difference in their dividend yield. But math is math and markets are markets, and in the long run, as Keynes famously remarked, we are all dead, sometimes because of what markets do to us in the short run.

The past seven and a half years have not been kind to the theory. From the end of 2008 to last Friday, the Russell 1000 Value Index has outperformed the Russell 1000 Growth Index by about 30%, and the MSCI Emerging Markets Growth Index has outperformed the MSCI Emerging Markets Value Index by about the same amount. While the Stoxx Europe Total Market Growth Index has outperformed the Stoxx Europe Total Market Value Index by a staggering 60%. These differences are for price returns; accounting for differences in dividend yields lowers the performance differentials to about 20%, 10% and 40% respectively.

Now the worm appears to be turning. Since mid-February, as energy and mineral prices have risen, value has outperformed growth in the U.S. and has performed in line with growth in Europe and in emerging markets. Even though the trend reversed sharply last Friday in Europe on the back of Thursday’s Brexit vote (the Stoxx 600 Growth Index outperformed the Stoxx 600 Value Index by 196 basis points). The reversal was, however, far more muted in the U.S. Just as one swallow does not make for spring, one reversal does not kill a trend. While we have seen false starts to a value rally in the past (in 2012-2013 in the U.S. and in 2013-2014 in Europe), the slowing of economic growth, along with the recovery in energy and commodity prices, has led to a bias in favor of value indices relative to their growth counterparts. On the growth side, scandals at various pharmaceutical companies have soured both the public and Congress on the industry and the exceptional returns of the sector have ground to a halt.

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