The Viability of the Value Premium Part IV: Future Expectations

If you’ve been following our series on value investing so far, you may be wondering what other evidence we have considered with respect to the factor’s future viability.

Going Global

First, it’s worth noting: While the United States is not the entire world, much of the press covering the value premium has focused on U.S. performance. Over the past decade or so, international value stocks have often performed more robustly than their U.S. counterparts.

In a 2018 ETF.com post, financial author Larry Swedroe commented: “If value is ‘dead,’ we should find confirming evidence in other [non-U.S.] markets.” He then used data from Ken French’s website to show that the premium was alive and well in international developed markets in the then-current 10-year stretch. Depending on which business metric he used, the value premium ranged from 1.9% (book/price) to 4.1% (earnings/price) from 2008–2017.

In financial academia, where assumptions are best validated by presenting across multiple markets and various timeframes, this suggests U.S. value stocks are more likely experiencing a random setback than defining a new global norm.

Popularity Contests and Future Expected Returns

In a more recent piece, Swedroe also rebutted the suggestion that value investing has become a victim of its own success. That is, as more investors have incorporated the value factor into their portfolios, has old-fashioned supply-and-demand eliminated its expected premium?

We don’t know for sure, but we don’t think so. It’s more likely that investors who cannot tolerate the recent underperformance are unwittingly setting the stage for the value factor’s comeback.

Think about it: Whenever one investor wants to sell their shares, somebody else has to buy them, or the transaction cannot occur. As some investors waiver and sell their value stocks at lowered prices, other bargain-hunting buyers swoop in and position themselves for future expected growth. Eventually, the pendulum is likely to swing. In a chicken-or-egg relationship, sentiments shift as prices crawl or lurch back upward. The next thing you know (although nobody knows just when), value has once again resurfaced, stronger than ever. The cycle begins anew.

That’s how efficient markets have worked for decades, if not centuries. It’s how they’re expected to continue to work moving forward. In other words, in an ironic twist, lower current prices actually suggest future higher returns.

We can point to supporting evidence from a stock pricing measurement known as the spread. In this case, the spread measures the difference between the price buyers want to pay for a stock (the bid) vs. the price sellers want to receive (the ask). Wider spreads mean bid/ask prices are far apart; narrower spreads mean they’re closer together.

As Swedroe observed in his paper, “If overcrowding has occurred, we should see a dramatic narrowing in [spread] valuations, as cash flowing into value stocks and out of growth stocks impacts relative prices.” After analyzing the spreads among various market factors, he concluded: “The bottom line is that we see no evidence that cash flows have caused the ex-ante value premium to narrow, either in small stocks or large stocks.”

To put it another way, J.P. Morgan’s chief U.S. equity strategist was quoted as follows in a June 2019 MarketWatch column (emphasis ours): “[V]alue is currently trading at the biggest discount ever, and offers the largest premium over the last 30 years.” The strategist was referring to future, not current expected premiums. In other words, for those who stick with the value factor, solid evidence remains that the best is yet to come.

So, where does all this leave us? We’ll offer a recap in our next, final segment.