Tactical Valuation Update – May 2021

Applied Finance will continue to monitor and report aggregate market valuation characteristics to help our research partners allocate capital in the current US equity landscape.  This update reflects aggregate valuation characteristics based on 4/30/21 closing prices, fundamental data availability and consensus analyst forecasts.

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).

• Large cap growth stocks have aggregate valuation characteristics 13.6% improved over large cap value peers (using Russell’s style methodology).  While passive large cap growth offers mild upside, passive large cap value is overvalued by nearly 10%.

•  Small/mid cap stocks are overvalued with aggregate intrinsic value upside of -13.5% in the Russell 2000 universe.

•  Small cap value stocks have aggregate valuation characteristics 3.9% improved over small cap growth peers, but both passive small cap style universes are overvalued by more than 10%.

•  Large cap stocks have aggregate valuation characteristics nearly 13% improved over small cap peers.

Tactical Valuation: Portfolio Construction Summary

• Cap-weighting S&P 500 constituents has aggregate valuation characteristics of 2.5%, more than 17% higher than an equal-weight alternative.

• Portfolios in the S&P 500 formed on attractive Valuation Stewardship characteristics (combination of Excess Intrinsic Value and Financing Yield factors) have aggregate intrinsic value upside of 21.2%, while stocks with poor Valuation Stewardship traits have aggregate upside of -23.1%.  Large cap investors benefit from deviating from fully valued passive allocations (or overvalued passive large cap value allocations) towards valuation-based portfolios that continue to offer upside potential.

•  Portfolios in the Russell 2000 formed on attractive Valuation Stewardship characteristics have aggregate intrinsic value upside of 12.2%, while stocks with poor Valuation Stewardship traits have aggregate upside of -45.2%.  Small/mid cap investors benefit from deviating from overvalued broad and style-based passive allocations towards valuation-based portfolios that continue to offer upside potential and avoid the significant downside risk of low valuation stewardship stocks.

 Tactical Valuation: Factor Summary

• High book to price stocks, based on the top 30% of Russell 3000 stocks, have aggregate upside of 0.6%, while low book to price stocks have aggregate upside of -3.9%.  The valuation gap on the HML factor currently reflects 4.5% relative upside in favor of high book to price stocks.

• The significant valuation gap that formed in early 2020 has since reverted to nearly zero following the recent outperformance of HML value stocks.

• Forming joint sorts on size and leverage risk factors in the Russell 3000, we continue to observe a valuation gap in favor of smaller, highly levered firms (“high risk”) relative to their larger, less levered peers (“low risk”).  High risk stocks have aggregate upside of 19.0%, while low risk stocks have aggregate upside of -10.2%, reflecting an overall valuation gap of 30.2%.

• This risk-based valuation gap peaked in early 2020.  This roughly aligns with small cap value (where book to price serves as a leverage proxy).  While small cap value has significantly outperformed since this valuation gap peaked, there is still a notable valuation gap in favor of small cap, highly levered firms that indicates this theme could continue until the valuation gap converges towards zero.

• Forming joint sorts on operating profitability and investment rate factors in the Russell 3000 (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, similar to levels noted during the tech bubble.

• The valuation gap between stocks returning capital and their dilutive peers (based on Fama French factors) has reached 50.2%, and the recent peak noted earlier this year exceeds any level observed since 1998.

• This returning capital vs diluting ownership theme can be directly captured in a single Financing Yield factor (Financing Cash Flows / EV).  The top 30% Financing Yield stocks in the Russell 3000 have aggregate upside of 9.0%, while the bottom 30% have aggregate upside of -26.0%.

• The Financing Yield valuation gap in favor of stocks returning capital is currently 34.9%.  Its recent peak earlier in 2021 also exceeds any level observed since 1998.

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