Many traditional value advocates are publishing material that points out the potential future benefit of value investing. It makes sense; they certainly cannot use recent performance when selling their investment process. This claim that “value is exceptionally cheap today” typically comes in the form of measuring value spreads, which divides a universe of stocks based on price multiples, then compares the current gap between low and high multiple stocks against historical observations. When studied with an intrinsic value framework, however, we note a mild valuation preference towards value stocks, although the historic nature of this claim is not observable.
Conviction with traditional value investing, in general, is rooted in the misconception that price multiples offer an adequate proxy to valuation. Deconstruction of price multiples with a systematic measure of comprehensive intrinsic value confirms that price multiples only help identify undervalued securities when they are correlated with intrinsic value. Outside of that, “cheap” stocks deliver negative alpha. Attempts to salvage value investing by deviating from the book to price factor defined in Fama French studies (with price multiple composites or adjusted multiples that capitalize intangible investment) do not correct the inherent flaws of cheapness investing. Our intrinsic value expertise forces us to reject the basic premise of using price multiples to form an investment thesis, and this applies to individual stocks and broad market aggregates.
Equipped with this perspective, we can apply systematically derived intrinsic value estimates to study these recent claims regarding the attractiveness of value stocks and see if they offer any merit for tactical consideration (in other words, to “sin a little”). To accomplish this, we first aggregate the Russell 1000 universe by cap-weighting the % upside offered by each stock on a default basis. We then divide the Russell 1000 into value and growth portfolios by incorporating the style methodology employed by Russell. Value is defined as book to price, and growth is a composite of sales growth per share over the last five years and earnings growth over the next two forecast years. These are further combined to assign an overall style classification for each portfolio constituent. The value portfolio is built on stocks with high book to price and low growth composite scores, while the growth portfolio is built on stocks with low book to price and high growth composite scores. We then aggregate each value and growth portfolio by cap-weighting the upside for each stock based on default intrinsic value estimates and current market prices as of each month end date since 1998.
Based on this analysis, we observe that a notable valuation preference towards value stocks took form in the late 1990s around the tech bubble, then persisted through the end of 2002. From that point forward, the cap-weighted valuation characteristics of value and growth stocks have generally moved in tandem with one another.
Applied Finance Research: Russell 1000 Cap-Weighted Intrinsic Value Upside, October 1998 to January 2021.
We further graph the valuation gap between value and growth stocks in the Russell 1000 in the chart below. At the end of March 2020, a noticeable valuation gap in favor of value stocks had formed, but this has since reverted to more normal levels. The current valuation gap between value and growth is 12.58%, which has a z-score of 0.59 compared to historical observations. While this affirms that there is modest relative upside offered by value stocks today, it pales in comparison to historic levels observed in the peak of the tech bubble.
Applied Finance Research: Russell 1000 Cap-Weighted Intrinsic Value Upside, October 1998 to January 2021.
It is also noteworthy that since 2002, growth stocks have tended to offer more attractive valuation characteristics through early 2020, which provides excellent insight to help explain why growth has outperformed value over the previous decade. This introduces a much larger theoretical question: if growth indices have structurally offered more attractive valuation characteristics over the last two decades, what exactly does “value” imply in a style context?
In our working paper, Valuation Beta, we elaborate on the flaws of cheapness investing and dividend discount frameworks that fail to adequately capture valuation principles in asset pricing. We also introduce asset pricing factors that incorporate intrinsic value and reinterpret Fama French theoretical frameworks to align with valuation and NPV principles. Excess Intrinsic Value measures a firm’s value in excess of common stock reported on the balance sheet. Financing Yield measures a firm’s financing cash flow yield to determine if stocks are returning capital to shareholders or reliant on external financing, which subsumes the profitability and growth factors. In tandem, these factors help us form high and low Valuation Stewardship portfolios.
Dividing the Russell 1000 into high and low Valuation Stewardship attributes based on valuation-based asset pricing factors highlights several notable themes:
1. High Valuation Stewardship stocks are trading at market prices generally supported by their intrinsic value estimates, while low Valuation Stewardship stocks are trading at significant speculative premiums.
Applied Finance Research: Russell 1000 Cap-Weighted Intrinsic Value Upside, October 1998 to January 2021.
2. In general, allocation towards high Valuation Stewardship offers improved risk-adjusted returns compared to its passive broad market or style-based alternatives (based on higher Sharpe ratios, positive information ratios, outperformance alongside lower beta, higher Sortino ratios, and lower standard deviation of monthly returns compared to the benchmark). These performance-based characteristics warrant strategic allocation consideration in any market environment.
Applied Finance Research: Russell 1000 Cap-Weighted Returns, October 1998 to January 2021.
3. Focusing on low Valuation Stewardship stocks, aggregate valuation characteristics have recently plummeted to levels last observed during the tech bubble.
Applied Finance Research: Russell 1000 Cap-Weighted Intrinsic Value Upside, October 1998 to January 2021.
This is particularly noteworthy, since the Russell 1000 sold off by nearly 37% between 2000 and 2002, which was heavily influenced by the three-year decline of low Valuation Stewardship stocks of in excess of 60% over that three-year horizon. Meanwhile, high Valuation Stewardship stocks provided much better capital preservation in 2000 and 2001 before selling off with the broader market in 2002. Between 2000 and 2002, high Valuation Stewardship stocks outperformed the Russell 1000 by more than 23%.
The relative unattractiveness of low Valuation Stewardship stocks observed today provides additional tactical consideration. The poor valuation characteristics embedded in their current market prices will likely drag on overall benchmark returns until these valuation levels normalize. This provides evidence that there is benefit from deviating from passive investment that exposes portfolios to this large basket of stocks.
4. We further study the valuation gap between high and low Valuation Stewardship portfolios to see an overall gap of 54% in favor of high Valuation Stewardship stocks, which provides a z-score of 0.78 compared to historical observations.
Applied Finance Research: Russell 1000 Cap-Weighted Intrinsic Value Upside, October 1998 to January 2021.
Our asset pricing study offers the theoretical framework and out-of-sample performance to support allocation towards high Valuation Stewardship portfolios. Using aggregate valuation data, we can contrast the valuation characteristics of value/growth portfolios against high/low Valuation Stewardship portfolios. While there is a noticeable, yet mild, valuation preference towards value stocks relative to growth, their absolute valuation levels appear overvalued by nearly 15%. Alternatively, a larger valuation gap has formed in favor of high Valuation Stewardship portfolios, and this portfolio offers aggregate valuation characteristics that much more fully support their current market prices. As a tactical opportunity, there appears to be strong evidence to allocate towards high Valuation Stewardship to preserve capital and away from low Valuation Stewardship to avoid their potential underperformance or benchmark drag.
In April, we will be adding an actively managed ETF to our roster of investment strategies. For launch updates and more articles like this, join our Valuation Edge™ newsletter.
Author
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Derek Bergen, CFA – Applied Finance Partner Joined Applied Finance, 2005. Portfolio Manager and Quantitative Research Analyst. B.S. University of Wisconsin-Madison.
