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Tactical Valuation Update – July 2021

Applied Finance will continue to monitor and report aggregate market valuation characteristics to help our research partners confidently allocate capital in rapidly changing US equity landscapes. This update reflects aggregate valuation characteristics based on 6/30/21 closing prices, fundamental data and consensus analyst forecasts. This month, we explore competing value and growth classifications, as well as the intrinsic value characteristics of commonly studied factor portfolios.

Many market participants disseminate ideas related to value and growth themes without clarifying the context in which these classifications are forged. As we summarize in the table below, there is often material nuance in the precise construction of style labels depending on the price multiples used to form “value” classifications and the growth attributes used to form “growth” classifications.

In addition to this, the notable tactical valuation themes we observe in the current marketplace indicate that large cap stocks are slightly more attractive than their small cap peers. We also observe that investors can improve a portfolio’s intrinsic value characteristics by allocating towards highly profitable, growing stocks away from low profit, dilutive peers.

Tactical Valuation: Size & Style Summary

  • Large cap stocks are fairly valued in aggregate (when incorporating analyst forecasts through 2024 before corporate performance and organic growth levels diminish over each firm’s unique Economic Profit Horizon). Small cap stocks have aggregate upside of -12.1%, indicating that large cap stocks offer cap-weighted upside nearly 13% higher than their small cap peers.
  • Large cap growth stocks have aggregate valuation characteristics 5.3% improved over large cap value peers (using Russell’s style methodology). While passive large cap growth offers mild upside, passive large cap value offers mild downside.
  • Small cap value stocks have aggregate valuation characteristics 10.8% improved over small cap growth peers, but both passive small cap style universes currently offer negative intrinsic value upside.
  • Morningstar’s style methodology expands to 10 factors (compared to 3 used in Russell’s methodology). Value is generally more attractive than growth, with a widening valuation gap in smaller arenas. Large value has 15.4% improved upside vs large growth. Mid value has 34.2% improved upside vs mid growth. Small value has 43.9% improved upside vs small growth.

Tactical Valuation: Portfolio Construction Summary (Position Sizing & Applied Finance Stock Selection)

  • A portfolio of market cap weight S&P 500 constituents has aggregate intrinsic value upside of 3.8%, more than 16% higher than an equal-weight alternative. This is largely due to the intrinsic value upside noted in the top 5 US stocks by market cap.
  • Intrinsic value weighting drastically improves the valuation upside of S&P 500 constituents over time. In addition to the strategic advantage found in forming position sizes on intrinsic value characteristics (instead of a market value proxy), the current valuation gap in favor of intrinsic value weighted portfolios of +26.2% is currently at its highest level since the early 2000s.
  • Similar benefits from intrinsic value weighting index constituents are also observed on a broader universe of US equities. The current valuation gap in favor of intrinsic value weighted portfolios is +32.1% compared to its market cap weighted alternative in the Russell 3000.
  • Portfolios in the S&P 500 formed on attractive Valuation Stewardship characteristics (combination of Excess Intrinsic Value and Financing Yield factors motivated from Applied Finance’s Valuation Beta research) have aggregate intrinsic value upside of 21.9%, while stocks with poor Valuation Stewardship traits have aggregate upside of -21.9%.
  • Portfolios in the Russell 2000 formed on attractive Valuation Stewardship characteristics have aggregate intrinsic value upside of 17.7%, while stocks with poor Valuation Stewardship traits have aggregate upside of -46.0%.

Tactical Valuation: Factor Summary

  • High book-to-price stocks, based on the top 30% of Russell 3000 stocks, have aggregate upside of 5.4%, while low book-to-price stocks have aggregate upside of -4.8%. The valuation gap on the HML factor currently reflects 10.2% relative upside in favor of high book-to-price stocks. The significant valuation gap that formed in early 2020 is now much closer to historical normal levels following the recent outperformance of HML value stocks.
  • Russell’s style methodology expands on book-to-price by further incorporating a growth composite of sales growth per share and earnings growth. When forming portfolios on this composite, we observe that the high growth portfolio has aggregate intrinsic value upside characteristics nearly 24.5% higher than the portfolio formed on low growth peers. Over the past twenty years, we have observed a structural preference towards stocks with higher growth characteristics; this persistent valuation gap highlights the role that sales and earnings growth play in shareholder wealth creation within an intrinsic value framework, providing evidence that value and growth can coexist.
  • High operating profitability stocks, based on the top 30% of Russell 3000 stocks, have aggregate upside of 14.8%, while low operating profitability price stocks have aggregate upside of -42.2%. The valuation gap on the RMW factor currently reflects 57.0% relative upside in favor of high profitability stocks.
  • Conservative investment rate stocks, based on asset growth in the bottom 30% of Russell 3000 stocks, have aggregate upside of 13.9%, while aggressive investment rate stocks have aggregate upside of -12.0%. The valuation gap on the CMA factor currently reflects 25.9% relative upside in favor of low growth stocks.
  • Forming joint sorts on operating profitability and investment rate factors in the Russell 3000 (motivated by Fama French’s expansion to five factors based on a deconstruction of a dividend discount model), we observe a significant valuation gap in favor of stocks returning capital to firm owners (based on high profitability and low reinvestment) compared to stocks diluting their shareholders (based on low profitability and high levels of reinvestment). Stocks diluting their shareholders currently have alarming valuation characteristics at -45.3% in aggregate, levels last observed during the tech bubble. The valuation gap between stocks returning capital and their dilutive peers (based on these Fama French factors) has reached 53.3%.
  • This returning capital vs diluting ownership theme can be directly captured by the Financing Yield factor (Financing Cash Flows / EV). The top 30% Financing Yield stocks in the Russell 3000 have aggregate upside of 11.0%, while the bottom 30% have aggregate upside of -24.8%. The Financing Yield valuation gap in favor of stocks returning capital is currently 35.9%. Its recent peak earlier in 2021 also exceeds any level observed since 1998.
  • High price momentum stocks, based on top 30% returns from previous year excluding most recent month of Russell 3000 stocks, have aggregate upside of -8.9%, while low price momentum rate stocks have aggregate upside of 2.3%. The valuation gap on the UMD factor currently reflects 11.2% relative upside in favor of low momentum stocks.

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Author

  • Derek Bergen, CFA – Applied Finance Partner  Joined Applied Finance, 2005. Portfolio Manager and Quantitative Research Analyst. B.S. University of Wisconsin-Madison.

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