Value Premium
Jim Williams
When we establish the investment policies we use to drive decisions about the investment portfolios we manage, we include in those conversations a discussion of premiums (premia - we'll use premiums here); most notably, the equity premium, the value premium, the size premium, and the profitability premium. The basic stock/bond split is the explicit pursuit of the equity premium. Further, we encourage our clients to specifically pursue the value and small premiums with portfolio tilts toward those factors. Part of the conversation includes the caveat that the premiums are not and have not been present at all times. In fact, there may be lengthy stretches of time wherein one or more premiums do not show up. The periods of time when the premiums do not show up are the risk side of the risk/return trade-off. Remember, in the capital markets, risk and return are inextricably linked. Higher returns are enabled (and not guaranteed) by higher risk.
Value Premium is but one of the premiums we pursue. Embedded in our investment approach is the pursuit of the equity premium, value premium, size premium, and profitability premium. We are focused here on value, but much of the rationale here tends to apply to the other premiums as well. The equity premium is the excess return expected by investing in stocks rather than in bonds. Stocks are higher risk than bonds and carry the prospect of higher returns. Likewise, value stocks are higher risk than growth stocks, and carry the prospect of higher returns. The essential story of value, though, is low price. In the shorthand of investment management, value stocks are low-priced stocks, and growth stocks are high-priced stocks.
It is axiomatic: the price paid for the purchase of a stock is based on expected future earnings of the company. Expected earnings are the source of the market value of a company. Different securities have different expected returns. Stocks have different expected returns than bonds, and stocks in value companies have different expected returns than stocks in growth companies. These differences are reflected in the price differential and discount rate. The discount rate describes the relationship of current price to future earnings. If you have two securities with the same future earnings and one has a lower price than the other, the lower priced security has a higher discount rate, and therefore has a higher expected return. This is fundamental finance.
The price differential between value and growth is illustrated by the weighted average price to earnings (PE) Ratios of the Russell 1000 (Large companies) and Russell 2000 (Small companies) at 6/30/2020. In the large cap space, growth has a PE of 32.93 while value has a PE of 20.67; in the small cap space growth has a PE of 32.04 while value has a PE of 18.95. This means for growth companies, you pay almost 33 times a single year's earnings to buy the growth index, whereas you pay about 21 times THE SAME EARNINGS to buy the value index. 21 times earnings is a lot cheaper than 33 times earnings.
As mentioned above, the premiums are not always present. Let's look at the history of equity, value, and size premiums from June 1927 through December 31, 2019 for 1, 5, and 10-year periods. In single years, the equity premium has been negative in 30% of the years, the value premium negative in 40% of the years and the size premium has been negative in 44% of the years. In 5-year periods, the equity premium has been negative in 21% of the periods, the value premium has been negative in 26% of the periods, and the size premium has been negative in 38% of the 5-year periods. For 10-year periods, the equity premium has been negative in 15 % of the periods, the value premium has been negative in 17% of the periods, and the size premium has been negative in 28% of the periods. This shows that the value premium lands between the equity premium and the size premium in terms of reliability. The recent experience of the dominance of growth for the last few years does not change our perception of this reliability.
The value premium has been negative in 10 of the last 20 years; 10 of the last 13; 7 of the last 10, and 5 of the last 6. This has been largely due to the spectacular performance of growth, and not so much a poor performance of value. For the 10 years ended June 30, 2020, the Russell 1000 Value has produced a respectable 10.41% annualized total return, whereas the Russell 1000 Growth has produced a spectacular 17.23% annualized. Small cap has lagged large cap during that time interval as well. Much of the performance of large growth has been attributable to the 5 tech giants Facebook, Apple, Amazon, Netflix, and Google (FAANG) stock returns.
We always expect positive value premiums. We see the existence of the value premium strongly supported by historical evidence in the data. We also see the value premium strongly supported in the theories of basic finance. The fact that the value premium has taken leave for the last few years is not a departure from what the evidence shows us; it is part of the expectation.
If faced today with the task of designing my own portfolio allocation, I would tilt toward the value and small cap premiums.
Premiums are volatile. They can and do show up very quickly and the only reliable way to harvest them is to remain focused on the designed allocation. This advice we regularly offer is sometimes the hardest to follow: don't do something; just sit there.
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The table below shows the returns through June 30, 2020 for selected investment asset classes. In most cases, the results below are appropriate benchmarks for the related mutual funds in your investment portfolio.
