The last 18 months have been an historical period of value factor underperformance. Risk-averse investors have turned stock prices upside down. Cheap stocks have been underperforming for the last 18 months, while expensive stocks are overperforming. The only comparable periods for value underperformance over the last 30 years are the Tech Bubble and the Global Financial Crisis (GFC). This comes as a surprise to many. We have been living through an extraordinary return environment that has, largely, fallen under the radar. Should investors be alarmed?
Not quite. We see the current value underperformance as a sign of tremendous opportunities ahead. Historically, overreactions like this have led to massive corrections. After both the Tech Bubble and the GFC, corrections were in excess of 30%.
Valuation spreads support our reasoning here. The difference between the cheapest and most expensive stocks is currently around the 90th percentile. This is extreme. In all prior periods we measured, that level of deviation in pricing has historically been followed by significant outperformance, as fundamentals revert to normal levels.
At the height of the Tech Bubble (1998-1999), the Russell 1000® Value Index (Value) underperformed the Russell 1000® Growth Index (Growth) by 35% cumulatively. But performance completely reversed over the following three years, as the bubble imploded, and Value outperformed by approximately 42%.
From the end of 2017 to mid-2019, Value again lagged Growth, this time by a cumulative 38%, as Growth ratings continued to march higher. In fundamental terms, a total of $1,000 invested during that time period in cheap, high quality stocks within the Russell 1000® Index would now yield $83 of earnings, compared to $61 at the start of 2018. This represents an increase of 36%.
Alarmists cry: this time is different! We don't agree. This value environment is extreme, but it is not unique. Some say that value is "broken" (i.e., something has fundamentally changed) or that value stocks currently represent a "trap." Our research does not support these conclusions. We tested the drivers of recent value underperformance to confirm this. In a value trap environment, we would expect a substantial deterioration in fundamentals. In the last 18 months, we have actually seen an improvement in fundamental earnings for value stocks, but a deterioration in pricing. This combination is unprecedented, and signals the opposite of a value trap environment.
To further test our conviction that value is poised for a correction, we vetted the buying behavior of value company insiders. In the current environment, corporate insiders have been buying their own value stocks at an accelerating rate. As of the end of June 2019, the correlation between corporate insider activity and earnings yield was close to three standard deviations above average, supporting our belief that there is a major performance opportunity for investors who hold fast.
Several potential catalysts could contribute to a rebound in value. Global growth or recession, policy stability and regulations that foster competition could all play a part. As long-term systematic investment managers, we understand how important it is to stay the course. Investment consistency and discipline are key.
Fundamentals for cheap stocks have remained resilient. In our view, the magnitude of cheap stocks' underperformance plus the outperformance of expensive stocks should add up to sizable corrections. We believe that QMA is well-positioned to gain from the impending rally. Since timing a return to value can be costly, our adaptive investment processes naturally tilt to value in conditions such as these.
Indeed, those who share our view may want to consider further rotating into value at a total portfolio level. We see the current environment as perhaps the finest buying opportunity for value in a decade - if not the last quarter century.
NOTES TO DISCLOSURE
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The comments, opinions and estimates contained herein are based on and/or derived from publicly available information from sources that QMA believes to be reliable. We do not guarantee the accuracy of such sources of information and have no obligation to provide updates or changes to these materials. This material is for informational purposes and sets forth our views as of the date of this presentation. The underlying assumptions and our views are subject to change.
Past performance is not a guarantee or reliable indicator or future results.