Fundamentals Provide Surprising Context on the Current Value Spread

Last week we initiated a multi-part analysis into Value, observing how the factor has performed since 1997 and highlighting its potentially oversold status. As it turns out, since publishing that article we’re seeing a slight rebound in the factor. On a normalized basis, Value in the US hit a trough of -2.95 standard deviations below the mean on 2/18, and has since ticked up to -2.87 SD below the mean. In the global model, the factor bottomed out at -3.01 SD below the mean on 2/10 and has since rallied back to -2.53 SD below the mean. If the trend holds, then we might already be in the first inning of a Value recovery.

If you recall, in last week’s analysis we took the top 2000 stocks by market cap in the Russell 3000 and ranked them from high-to-low based on their Value factor exposure. We then created a Value Long/Short portfolio that is long the top quartile of Value names (highest Value exposure), and short the bottom quartile of Value names (Anti-Value exposure), rebalancing it on a monthly basis.

Today, we’ll break the Value portfolio into its Top Quartile and Bottom Quartile components, so we can separately analyze each quartile’s performance and fundamental trends versus one the most egregiously known Growth/Value disparity periods: The Dot Com Boom/Bust. We’ll also provide our weekly market and factor update.

Value Portfolio Historical Performance: Top Quartile vs. Bottom Quartile

Since the last decade has been a bull market, to get a sense of relative out(under)performance we compare the performance trends of the Top and Bottom Quartile Value portfolios versus the Russell 3000 (R3K).

As expected, the Bottom Quartile (14.6% annualized return) substantially outperforms both the R3K (12.7% annualized return) and the Top Quartile (8.25% annualized return). But what’s somewhat surprising is that the Bottom Quartile’s Annualized Volatility (17.52%) is lower than the Top Quartile’s Annualized Volatility (17.67%). Said differently, an anti-Value investor over the last decade didn’t experience any higher risk than his Value investor counterpart while enjoying 6.3% excess return per year!

Furthermore, both the market downturns Q4 2015 and Q4 2018 we observe an interesting phenomenon - the Bottom Quartile’s performance does not appear converge with the Top Quartile’s.

This is quite different than what we saw during the the dot com boom & bust (shown below) where the Bottom Quartile peaked in March 2000 and then drew down well into 2003.

‍*Peak: March 6, 2000

Investors clearly haven’t viewed Value stocks as a safe haven during the recent market corrections.

‍To better understand why, we examine the fundamental and sector characteristics of the Top vs Bottom Quartile to see how they may differ from Dot Com boom/bust period.

Fundamental Characteristics of The Value Portfolios: Top Quartile vs. Bottom Quartile

Dividend Yield

Unlike the dot com boom / bust, we see that the respective dividend yield exposures of the Top and Bottom quartiles have continued to diverge in the past decade, and the spread is now largely where it was at the peak of the Dot Com Boom: 1.17 standard deviations vs 1.38 standard deviations in March 2000.

May 2010 - Current

Jan 1997 - Jan 2003

Earnings Yield

‍Earnings Yield exposure is a combined metric of:
(a) the trailing 1 year Net Income / Market Cap ratio
(b) the forward 1 year Analyst Net Income Estimate / Market Cap ratio.

Below we see that the current (Feb 2020) Earnings Yield exposure spread for the Top and Bottom quartile of Value is 0.46 vs 1.19 in March 2000. Meaning, at current Valuation levels relative to Earnings, there’s a historical precedent for an even wider spread between Value and Anti-Value stocks.

‍May 2010 - Current

Jan 1997 - Jan 2003

Growth

‍Growth exposure is a combined metric of both forward and trailing earnings & sales:
(a) 5 year trailing and 1 year forward earnings growth rate
(b) 5 year trailing and 1 year forward sales growth rate

Since 2016, the spread between the top and bottom quartiles has been very consistent (currently at -0.36) but has been much larger historically (-0.95 on October 31, 2011). Even the peak of the Dot Com Boom/Bust the spread contracted to -0.39, which still exceeds current levels. That essentially means that if growth expectations of the Anti-Value and Value stocks go wider, it would drive Valuations even further apart.

May 2010 - Current

Jan 1997 - Jan 2003

Profitability

‍The Profitability exposure combines several ratios that determine the quality of a company’s business: Return-On-Equity, Return-On-Assets, Cash Flow-to-Assets, Cash Flow-to-Income, Gross Margins, and Sales-To-Assets.

‍The below charts comparing recent history vs the Dot Com period are perhaps the most stark: Bottom Quartile Value stocks have maintained a positive Profitability exposure spread over the Top Quartile (currently +0.12), while between Sep 1999 and Feb 2001, the spread completely inverted, widening at its most extreme to -0.58 on February 21, 2000.

‍May 2010 - Current

Jan 1997 - Jan 2003

Conclusion:

“History doesn't repeat itself but it often rhymes” (Mark Twain).

‍While we recognize that every market environment is different, we do see many parallels to the period of the Dot Com boom.  Leveraging that fact, we’ve shown across multiple fundamental spread characteristics (Earnings Yield, Growth, Profitability, and Dividend Yield) that in fact, spreads have been wider during the peak of the Dot Com Boom. Amongst all of the fundamental characteristics, the Profitability spread may help us determine whether to expect a near-term Growth/Value reversion, and according to that metric we’re certainly not that close.  

Next week, we’ll wrap up our series with further analysis on the Value portfolio at a sector level, and aim to show fundamental investors how to leverage other factor lenses to screen for undervalued/overvalued stocks in the current market environment.

US & Global Market Summary

US Market: 2/14/20 - 2/20/20

• Stocks broadly saw weakness on Friday (not captured in above chart), with the major indices ending lower on the week. The downward move has been largely attributed to investor concerns around the spread of COVID-19 (especially to South Korea) and the follow-on impact to global supply chains and economic growth.
• Yield on 30-year Treasuries broke an all-time low as fears related to the coronavirus sent investors flocking to risk havens. Yield on 10-year Treasuries fell to a five-month low of 1.47%.
• Oil futures also ended with a loss on Friday, stemming from reports of a rift in the crude-production alliance between Saudi Arabia and Russia, as well as concerns about the virus’ impact on energy demand.
• The IHS Markit purchasing manager survey’s composite index for the US fell to 49.6 in February, marking a six-year low.

‍Factor Update: Axioma US Equity Risk Model (AX-US4)

• As mentioned earlier, Value saw a slight tick up for the first time in a while, as it had been nearing almost 3 standard deviations below the mean.
• Market Sensitivity and Volatility both saw gains on a normalized basis, with Volatility exiting Oversold space and Market Sensitivity attempting to do the same.
• Size inched up towards the cusp of Overbought territory, now sitting at +0.99 SD above the mean.
• Earnings Yield continued to revert back towards the mean, although still remains an Oversold factor.
• After seeing normalized weakness over the past couple of weeks, Profitability saw a slight tick up to -0.49 SD below the mean.
• After seeing a modest dip last week, Growth ticked up but remains in Overbought territory.
• US Total Risk (using the Russell 3000 as proxy) fell by -0.13%.

‍Factor Update: Axioma Worldwide Equity Risk Model (AX-WW4)

• Size has been a fast riser after exiting negative territory on 2/11, and is now in knocking distance of being Overbought at +0.89 SD above the mean.
• Earnings Yield continued to see some strength, +0.3 standard deviations as it climbs out of Oversold territory.
• Value continued to see positive momentum as it climbed out of Extremely Oversold space, now sitting at -2.53 SD below the mean.
• Profitability continued its multi-week plummet, and is close to entering Extremely Oversold territory.
• Global Risk (using the ACWI as proxy) fell by -0.11% this week.

Regards,
Omer