Value Spreads for Hypothetical Long-Short Value Portfolios.*
*U.S. Large represents the top decile minus bottom decile based on OSAM Value Composite—sales-to-price, EBITDA-to-enterprise value, earnings-to-price, free cash flow-to-price, shareholder yield. Spreads are measured as ratio of the earnings-to-Price of each decile. Stocks with negative earnings are excluded from the analysis. DM Large and EM Large are measured in the same manner on universe quintiles.
We often get asked whether value stocks are “cheap”. The short answer is “yes”, but they have been cheap for a while. This important caveat underscores the fact that valuation tends to be a poor timing mechanism for all but true long-term investors.
To answer whether value stocks are “cheap”, we assessed large cap stocks across U.S., Developed, and Emerging Markets. Stocks within each market were divided into groups by our value theme, which ranks for sales, cash flows, and earnings relative to price. After establishing these groups, we calculated the price-to-earnings (PE) ratio of each group and evaluated the spread between PE ratios of the cheapest and most expensive group.1 A higher spread suggests value is cheap relative growth.
The chart above illustrates this “value spread” in each market over time. The previous standout episode of value “cheapness” in the late 1990s preceded the Tech Bubble. This valuation dislocation was obvious, but difficult to act on given the relentless rise of growth stocks. Growth outperformed throughout the late 1990’s in dramatic fashion, but value subsequently outperformed from roughly 2000 to 2007.
A similar episode of market “irrationality” has persisted in recent years as growth stocks have generally been the market leaders. The distortion was most prevalent in the U.S. as COVID exacerbated the dominance of growth stocks. At the end of 2021 value was cheaper (relative to growth) than at any point in at least 35 years—even in spite of the favorable environment we’ve experienced for value over the last year.
For long-term investors, the data suggests that value allocations may be an interesting opportunity. In light of the recent spike in inflation, we released a white paper on the historical impact of inflation on factor returns: The Great Inflation, Factors, and Stock Returns. This research further suggests that a value-bias during times of heightened inflation may be additive to total returns.
FOOTNOTES
1 The U.S. is grouped into deciles while non-U.S. is grouped into quintiles. Stocks with negative earnings are excluded from the analysis. Value spread is measured as a ratio of earnings-to-price for the cheap versus the expensive group in each market.
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