Historically bad to historically good

Value investors who chose to stay the course through the last few years were finally rewarded for their discipline!

Although it’s hard to believe, if we back up just a few months, the one-year period ending September 2020 was the worst return ever for small value stocks relative to larger, more growth companies, with small value underperforming by a whopping 52%. The three-year returns were also abysmal, with small value underperforming large growth by nearly 26% per year, which is close to the performance disparity we saw during the tech bubble in the late 1990s. However, with the benefit of hindsight, we now know that September 2020 was the low point, as value stocks roared back to earn nearly 50% more than large growth stocks over the next two quarters.(1)

Premiums show up in waves Despite clocking in at an annual average of 4% per year since 1927, the value premium is not earned steadily.(2) Rather, it comes in quick waves. The last few years have reminded us that trying to time the market, or even the value premium, can be detrimental to a portfolio’s overall growth. Looking at returns since 1972, Graph 1 shows that a dollar hypothetically invested in small value stocks would have grown to over $400 compared to just $173 for the same dollar invested the total U.S. stock market, a healthy premium of almost $240. But by missing just the five best months for small value stocks during that period, your hypothetical dollar would have only grown to $160, falling short of growth in the total stock market. That’s why the best way to capture the value premium is to stay invested consistently – even through the inevitable underperformance.

Relative earnings show potential for more outperformance Despite their exceptional performance recently, we know that prices continue to be depressed for small value stocks relative to history. One way to gauge whether stocks are expensive or cheap is to look at the difference in price-to-earnings ratio between small value companies and large growth companies. Historically, a dollar of earnings from large growth companies has cost roughly twice as much as a dollar of earnings from a small value company.(3) However, we can see in Graph 2 that earnings from large growth companies have become more than 3.5 times as expensive as earnings from small value companies. From this perspective, small value companies have yet to recover to where they were in late 2017, when the drastic underperformance started.

No one can reliably predict what markets will do next. And many factors could cause small, distressed companies to fall in price again. But with valuations at historically high spreads, we can be optimistic about seeing favorable performance from small value stocks that allows disciplined investors to continue reaping the rewards of their patience.

By Daniel Campbell, CFA
1. Morningstar Direct. Small value returns are measured by the Russell 2000 Value Index and large growth returns are measured by the Russell 1000 Growth Index.
2. Ken French Data Library. Represents the average annual premium from 1927-2020.
3. Ken French Data Library, Dimensional. The historical average price-to-earnings ratio from June 1963 through March 2021 was 10.8 for small value compared to 21.7 for large growth companies. June 1963 is the first month of data.
The content presented here is for informational purposes only and should not be construed as specific investment, accounting, legal or tax advice. Certain information is based on third-party data which may become outdated or otherwise superseded without notice. Third-party data is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. Hypothetical value of $1 invested at the beginning of 1972 and kept invested through April 2021. Assumes reinvestment of income and no transaction costs or taxes. This is for illustrative purposes only and is not indicative of any investment. Indexes are unmanaged baskets of securities that investors cannot directly invest in. Index performance does not reflect the fees and expenses associated with the management of an actual portfolio. Information from sources deemed reliable, but its accuracy cannot be guaranteed. Performance is historical and does not guarantee future results. Dates chosen based on availability of data. IRN-21-2260