Valuation vs. Cheapness in Tactical Allocation

Several weeks ago, Applied Finance hosted a webcast where we reviewed aggregate market valuation characteristics across the US equity landscape.  In this, we noted a structural intrinsic value preference towards growth stocks since 2002.  While a mild value preference formed in April 2020, it has since normalized as value stocks have outperformed over the last two quarters.  This observation is at odds with a recent publication from a traditional value manager (The Long Run Is Lying to You, AQR), which claims a historic book-to-price spread in favor of value stocks.

Given the weight of this decision in asset allocation, we want to explore these competing observations regarding the relative attractiveness of value and growth stocks.  An increase in “HML value spreads” offer a simple, yet enticing, narrative to help investors anticipate substantial mean reversion between value and growth portfolios.  To ensure reliable conclusions, however, we believe it is important to study these claims in the context of a comprehensive valuation framework on portfolios formed in a consistent manner with published style methodologies.

This also provides an opportunity to explore the valuation vs. cheapness theme in the context of asset allocation.  Applied Finance research has long proven that there are no shortcuts to forming a valuation thesis at the individual stock level, and this certainly should hold true when attempting to aggregate the characteristics of individual stocks across the entire US equity landscape.

Russell 1000 Value vs. Growth – Intrinsic Value Characteristics:

We can start by analyzing portfolios directly tethered to the published style methodology applied by FTSE Russell. This highlights that value stocks were relatively undervalued compared to growth stocks through the tech bubble.  Since 2001, however, growth stocks have structurally offered improved intrinsic value relationships.  By 2002, this relative upside has averaged nearly 20% in favor of growth stocks, with only temporary seasons of the valuation gap shrinking to a level around zero in 2007, 2010/2011, and early 2020.  By the end of February 2021, the valuation gap that mildly favored value stocks in 2020 had reversed, with 11.8% relative upside now noted in favor of growth stocks.

Russell 1000 Value vs. Growth – Incorporating a Price Multiple Composite

We believe that the concept of “value” in an investing context has become inherently muddled due to a myriad of price multiples and composites applied across the investment landscape.  While our valuation expertise allows us to confidently reject the premise of any price ratio as a valuation proxy, our recent research has emphasized the book-to-price (HML) factor due to its prominence in asset pricing studies and style methodologies.

While Applied Finance had no role in ushering in the use of book-to-price in asset pricing or style convention, we are forced to study its implications and shortcomings due to the universal acceptance in each of those arenas.  But we also understand the ease in which lobbing “strawman” criticisms can obfuscate the focus on the underlying flaw inherent in using price multiples to form a valuation thesis.  With that in mind, we have proactively incorporated a price multiple composite (using book-to-price, earnings to price, and sales to price, consistent with the S&P methodology) as the value composite to create an additional “value” perspective better aligned with the focus of traditional value advocates that have abandoned the HML factor.  This continues to incorporate Russell’s growth composite to form an overall style classification.

Based on this alternative approach, we observe a long-term normal valuation gap between value and growth slightly above zero percent on average.  Similar to our first example, there was a significant valuation gap in favor of value stocks during the tech bubble.  Growth stocks, defined with this modified methodology, have generally been considered more attractive since 2014 until a strong value preference emerged in April 2020.  This has since normalized, although the current preference towards value stocks of 3.6% relative upside is an improvement over the previous approach’s valuation gap of -11.8% when using book-to-price as the sole factor in the value composite.

Either way we define a style composite, the valuation characteristics between value and growth stocks do not allude to a historic valuation premium that would predict significant outperformance expectations of value stocks over long horizons.  There was a clear, discernable intrinsic value preference towards value stocks that formed in the tech bubble, which provided valuation-based evidence to highlight that the ensuing outperformance of value stocks was indeed rational.  The recent evidence of a milder valuation gap has already diminished through the value rally that already has occurred over the previous two quarters.  Value stocks may certainly outperform in the near-term as investors rotate out of digital disrupters as the economy reopens or as bond yields rise, but it will not be due to a structural disparity in the current relative valuation characteristics between value and growth stocks.

Valuation vs. Cheapness in Portfolio Construction

Applied Finance emphasizes that investors benefit from awareness of the contrast between intrinsic value and price multiples in portfolio construction.  In short, the presumption that seeking undervalued securities is no longer a necessary consideration in portfolio construction is misguided.  The abandonment of securities analysis principles and net present value techniques widely applauded in modern finance is problematic to us, and the deconstruction of book-to-price against an intrinsic value framework provides overwhelming out-of-sample evidence to support forming portfolios on undervalued securities regardless of their book-to-price characteristics.

Deconstruction of price multiples with a comprehensive intrinsic value framework that incorporates profitability, growth, competition, and risk provides evidence that price multiples are only effective to the degree that they correlate to intrinsic value classifications; outside of that, they underperform and offer significant negative alpha.  This provides important context for our write-up today.  If “cheap” book-to-price valuation claims unsupported by intrinsic value provide a significant source of negative alpha in portfolio construction, investors should view the tactical calls based on book-to-price skeptically.  With that in mind, we can shift our focus away from individual security selection and explore valuation vs. cheapness through a top-down allocation lens.

Reconciling the Intrinsic Value “Valuation Gap” and the HML “Value Spread”

Using our live datasets from October 1998 forward, we can adequately approximate the “Value Spread, Book-to-Price” chart offered in AQR’s recent write-up in our overlapping study horizons by modifying the construction parameters applied in our first set of charts.  Instead of relying on the interaction of the book-to-price value classification and a growth composite to form an overall style preference, we are now forming portfolios solely on the book-to-price, or HML, factor.  In other words, high book-to-price stocks form our value universe and low book-to-price stocks form our growth universe.  Also, we were required to expand our stock universe to include the entire Russell 3000 and rely on median intrinsic value characteristics instead of cap-weighting the dataset.

The intrinsic value spread between value and growth stocks noted here is similar to the “Value Spread” provided by AQR.  From this perspective, broad market, equal-weight portfolios formed solely on book-to-price do appear to offer evidence of a valuation gap that, at its peak in mid-2020, was similar to levels noted in the tech bubble.  Despite the recent outperformance of value stocks, the valuation gap at the end of February 2021 still appears to offer 55.9% relative upside in favor of value stocks.

This approach, however, has two obvious criticisms.  First, the formation of portfolios on the HML factor untethered to the growth factors commonly used in style composites is studying a “value” classification that is not consistent with the common style methodologies used in practice.  Second, by averaging observations across the entire US equity landscape, this further deviates from cap-weighted style indices and introduces concerns related to the investable nature of this observation.

Recasting our previous reconciliation in the context of cap-weighted Russell 1000 portfolios paints an entirely different narrative, where the valuation gap of 55.9% in favor of value stocks shrinks to 9.4%.  As we noted in our first section of this write-up, building these charts directly aligned to the style methodology employed by Russell further pushes the valuation gap to 11.8% in favor of growth stocks.

Due to these observations, we believe investors should tread carefully with the blanket claim that value stocks look incredibly cheap.  While value classifications based solely on HML may have elevated book-to-price estimates relative to growth stocks on average in an all-cap setting, it is critical to distinguish that these observations fade when a comprehensive valuation framework is used to study style methodologies commonly used in value and growth classification in practice.  At the same time, we can affirm the “value spread” on HML appears to be driven by its small cap exposure; there certainly may be potential benefits towards forming equal-weight, actively managed portfolios on high book-to-price stocks in a small cap context based on this observation.

Exploring the Role of Profitability and Growth in Wealth Creation

As we noted earlier, high multiple stocks that are undervalued in an intrinsic value framework have delivered significant alpha against commonly cited asset pricing models.  This introduces an interesting thought experiment.  Obviously, if your valuation toolbox only includes price multiples, it seems reasonable to presume that a price ratio increasing by a factor of two implies that a stock is twice as expensive.  Do higher multiples really imply that stocks are more expensive, though?  Or can an undervalued stock trade at higher multiples as investors become optimistic about long-term abnormal profitability and growth before actual retained earnings flow into the balance sheet?

Ultimately, price multiples are incapable of capturing the wealth creation of megacap stocks that are highly profitable, reinvesting in their business, and building significant competitive advantages to allow them to capture excess profits over significant Economic Profit horizons.  There are numerous other reasons that can explain why the value spread based on book-to-price has expanded, some related to valuation concepts, others tethered to accounting convention and financing decisions.  These provide sources of reconciliation between the HML value gap and its conflicting signal with a comprehensive valuation framework.

1. The exclusion of intangible investment in GAAP accounting. (iHML attempts to correct this, but omits that the adjustment is likely better handled as a corporate performance measure)
2. The reduction of book equity by highly profitable firms repurchasing shares at much higher prices than their initial offering prices steering book equity towards zero as organic growth slows.  (Deregulation occurred in 1982, and the “value premium” has been negative from that point forward in a Fama French 5 factor context)
3. The historically low borrowing rates that profitable, low levered megacap firms can access, further exacerbated when this incremental debt is used to repurchase shares.
4. The omission of a “winner take all” framework that benefits highly profitable megacap names continuing to heavily reinvest in their businesses (AAPL, GOOGL, AMZN, FB)

In this section, we simply want to focus on the interaction of profitability and growth in an intrinsic value framework (also, consistent with the common best practice of corporate finance, capital budgeting, and securities analysis).  To explore this, we can use the Shareholder Value Matrix derived from our intrinsic value and corporate performance framework.  From this, a conditional preference tethered to growth is based on a firm’s level of economic profitability.  Profitable firms should grow, but as profitable reinvestment opportunities fade, firms should return capital to shareholders.  Unprofitable firms should identify their core competencies before reinvesting in their business, which likely requires divestment.  The expected return of unprofitable firms that continue to reinvest in their business is where our framework overlaps with the investment rate factor as a predictor of negative future stock returns.

With this framework in mind, we want to explore the structural differences of profitability and capital growth between value and growth stocks.

Since 2010, the Economic Margins of growth stocks have improved from 8.7% to 16.7% by the end of 2019 on a cap-weighted basis.  At the same time, value stocks generated Economic Margins of 2.3% that climbed to 5.6% over the same horizon.  EM levels have fallen across the board as 2020 fiscal year data has started to become available through SEC filings, but investors will likely anticipate improving profits beyond 2021 as the economy reopens.

Alongside higher profits, growth companies have been able to deliver organic reinvestment rates between 10 to 14% per year since 2010, while value stocks have offered diminished reinvestment rates between 4 to 6% per year.  While Applied Finance prefers to view profitability through an economic cash flow lens and growth as an organic rate of reinvestment, we can further study Fama French measures of profitability and growth consistent with the tautology used in their five-factor paper to determine if similar patterns emerge.

The Fama French 5 Factor paper introduced a dividend discount model to motivate a preference towards high profitability (using a factor similar to ROE) and low/negative growth (using the previous year’s percent change in total assets), but this overlooks an important interaction of highly profitable firms reinvesting in their business and the wealth compounding characteristics that this creates for shareholders as organic cash flows are reinvested into incremental positive NPV opportunities.

Value stocks had higher operating profitability levels compared to growth stocks at the start of November 2000 (34.2% vs. 33.2%).  Since then, growth stocks have seen their operating profitability levels increase to 49.9% while value stocks have seen levels fall to 21.1%.  Even more recently, growth stocks have seen operating profitability climb from 40.6% to 49.9% from early 2015 onward while the profits of value stocks have stagnated just above 20%.  In addition, growth stocks have generally offered higher investment rates since 2002.

The structural differences regarding the increasing profitability levels and elevated year-over-year investment rates of growth stocks appear through both an economic lens as well as the factors posited by Fama French.  The compounding benefits of wealth creation when abnormal profits are reinvested into positive NPV opportunities over long horizons can be captured in an intrinsic value framework, and the actual reporting of retained earnings from this activity used in book-to-price will significantly lag a prudent investors ability to form expectations on the persistence of these abnormal profits.  Because of this, the structural outperformance of growth stocks over the last decade has been due to a valuation gap in favor of growth stocks, indicating that their market prices in aggregate were slow to incorporate increasing profits, high growth rates, and lengthening Economic Profit Horizons as profitability levels stabilized (especially for megacap technology stocks).

In addition, we can compare the size and leverage characteristics of value and growth stocks.  In general, growth stocks have higher market caps and lower leverage ratios, implying that they are less risky than their value peers (based on the size and leverage premiums tethered to Fama French’s 3 factor paper) and likely subject to lower discount rates.  This ultimately begs a different question: if traditional “value investing” reflects a preference towards highly levered stocks with low profitability and low growth prospects, why do so many investors conflate this investment style as having a valuation discipline?

The Valuation Stewardship Alternative

Applied Finance seeks to construct portfolios on undervalued securities regardless of their value or growth classification.  We can incorporate the factors motivated from our ”Valuation Beta” paper that reimagines asset pricing factors aligned with securities analysis principles.

Intrinsic Value in excess of common stock reported on a company’s balance sheet subsumes the operating profitability factor.  Financing Yield reimagines the tautology that introduced the operating profitability and investment rate factors to eliminate the naïve assumption that high growth unconditionally is a predictor of negative stock returns.  These factors can be used in tandem to form “Valuation Stewardship” portfolios.  High Valuation Stewardship has returned 1.55% of annualized alpha against the Fama French 5 Factor Model, and the long-short vs. the Low Valuation Stewardship has delivered annual alpha of 2.93% on a risk-adjusted basis.

By emphasizing intrinsic value in excess of reported levels on a firm’s balance sheet, High Valuation Stewardship stocks tend to have low book-to-price characteristics and elevated operating profitability levels compared to Low Valuation Stewardship peers.

Valuation Stewardship also emphasizes returning capital to shareholders (vs. diluting shareholders through incremental equity and debt offerings).  Due to this, High Valuation Stewardship stocks tend to have lower investment rates in aggregate by ignoring dilutive growth.  Reinterpreting the clean surplus deconstruction of dividends into profits and changes in book equity, however, we are not emphasizing an unconditional preference towards low growth, instead focusing on financing cash flows that return capital to shareholders or pay down priority claims over common equity holders.

As we noted above, style-based “value” portfolios have been associated with smaller, highly levered firms.  High Valuation Stewardship portfolios, on the other hand, are typically formed on larger firms with lower leverage characteristics.

Valuation Stewardship Tactical Observation

We believe that there is overwhelming evidence to support strategic allocation through a Valuation Stewardship lens, based on the theoretical foundation of the Economic Margin framework, its out-of-sample alpha characteristics, and the overlooked role of intrinsic value in asset pricing.  In addition, we also see compelling tactical consideration warranted in the current marketplace.

An enhanced degree of valuation agnosticism has taken hold as many investors have opted for passive or factor-based investment strategies over the past decade.  Alongside this, many stocks have become highly crowded as benefactors of the COVID/WFH themes that have dominated investor preference over the past year and may likely unwind as the economy fully reopens as the vaccine rollout continues.  Due to these trends, there is compelling evidence to avoid stocks with Low Valuation Stewardship attributes.

On a cap-weighted basis, Russell 1000 stocks are priced roughly 2% below intrinsic value estimates that incorporate forecast data through 2024.  This is well below historic normal levels that suggest 30% upside on average.  By allocating away from Low Valuation Stewardship stocks, with aggregate intrinsic value characteristics more than 30% below current market prices, investors can still find attractive upside of 24.2% in High Valuation Stewardship stocks.

Conclusion

A full exploration regarding tactical claims on value and growth portfolios is warranted to help investors form allocation decisions amidst the significant price movements that have occurred over the past year while markets transition into a new era defined by the unwinding of COVID/WFH trends.  While a book-to-price spread in the context of the HML factor has emerged on an equal-weighted, all-cap basis, investors benefit from understanding that this does not translate into an intrinsic value thesis in the context of style methodologies that are commonly used in practice.  In that regard, growth stocks appear to offer improved intrinsic value characteristics on a relative basis when comparing Russell 1000 Value and Russell 1000 Growth alternatives.

Further exploration of the valuation preference towards growth stocks over the last two decades highlights the importance of understanding the wealth compounding benefits of reinvesting abnormal profits into incremental positive NPV opportunities.  Growth stocks have delivered increasing profitability levels and elevated investment rates compared to their value peers, which explains the outperformance of growth observed over the last decade as rational and reflective of their improved fundamentals in an intrinsic value framework.  While we cannot affirm a material style preference towards growth or value in the current marketplace, we do see strong evidence that investors should avoid stocks with poor Valuation Stewardship characteristics.

Many investors have abandoned their security analysis discipline in the search for low-cost investment products, and most academic research has applauded that decision for decades.  Applied Finance has established an extensive out-of-sample systematic track record to confidently defy these trends with a disciplined valuation approach.  Because of this, we believe investors benefit from valuation-based investment decisions, not only at the individual stock level, but also by aggregating data across entire investment landscapes.  While notable regime shifts between value and growth preferences can be studied with an intrinsic value framework, we encourage investors to consider a comprehensive valuation metric in all of their stock selection, portfolio construction, and asset allocation decisions.

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