HOW SMALL VALUE STOCKS REBOUNDED
Over the period 2017-2020, U.S. small value stocks experienced a historic drawdown relative to U.S. large growth stocks. Over this four-year period, the Fama/French U.S. Large Growth Research Index returned a cumulative 135 percent versus the cumulative return of just 14 percent for the Fama/French U.S. Small Value Research Index. (During this period the S&P 500 Index returned 81 percent.) That degree of underperformance led to the growth index outperforming as far back as 2002!
Small value stocks began a dramatic recovery in late 2020. As an example, the Bridgeway Omni Small-Cap Value Fund (BOSVX) returned 91 percent over the one-year period ending November 5, 2021, outperforming Vanguard’s S&P 500 ETF (VOO), which returned 36 percent, by 55 percentage points. Despite that dramatic outperformance, BOSVX’s performance still trailed VOO’s over five- and 10-year periods by significant margins, 5.6 percentage points and 3.3 percentage points, respectively. With that said, it is important to note that BOSVX’s valuations relative to VOO’s indicate that U.S. small value stocks are still selling at historically cheap valuations relative to the market, and to growth stocks in particular. As Adam Zaremba and Mehmet Umutlu, authors of the 2019 study “Strategies Can Be Expensive Too! The Value Spread and Asset Allocation in Global Equity Markets,” demonstrated, the valuation spread provides information as to the future expected premium—the wider the spread, the larger the expected outperformance. With that in mind, using data from Morningstar, we can examine current valuations.
At the end of the third quarter 2021, BOSVX had a P/E of 9.9 as compared to a P/E of 28.3 for VOO—a ratio of 2.9. Eight years earlier (at the end of 2013), before the expansion of the P/Es of growth stocks, BOSVX had a P/E of 11.0 versus 17.9 for VOO—a ratio of 1.6. Thus, on a relative basis, small value stocks are still trading 80 percent cheaper than they were in 2013. This is despite the fact that value company earnings are now growing faster than those of growth companies as their earnings recover from the cyclical lows caused by the pandemic. Also note that small value stocks are selling cheaper today than they were in 2013 despite the fact that interest rates are much lower.
While the valuation spreads are not as dramatic as they are in the U.S., value stocks are selling at much lower valuations around the globe. For example, Vanguard’s FTSE Developed Markets ETF (VEA) had a P/E of 14.2, while Dimensional’s International Small-Cap Value Fund (DISVX) had a P/E of just 9.0. And Vanguard’s FTSE Emerging Markets ETF (VWO) had a P/E of 12.3, while Dimensional’s Emerging Markets Value Fund (DFEVX) had a P/E of just 7.6.
Over my more than 25 years of experience as Buckingham’s chief research officer, I’ve learned that one of the greatest mistakes investors make is that when it comes to judging the performance of risk assets, they think three years is a long time, five years a very long time, and 10 years an eternity. On the other hand, any financial economist would tell you that when it comes to risk assets, 10 years is likely nothing more than “noise.” Thus, such periods should not cause you to abandon a well-thought-out plan and make the mistake known as resulting—judging the quality of a decision by the ex-post outcome instead of by the quality of the decision-making process.
As Warren Buffett has advised, when it comes to investing, temperament trumps intelligence. Thus, discipline and patience are the necessary ingredients for investment success. The historic drawdown in value stocks was not due to poor company performance in the form of disappointing earnings. In fact, Robert Arnott, Campbell Harvey, Vitali Kalesnik and Juhani Linnainmaa, authors of the 2019 study Reports of Value’s Death May Be Greatly Exaggerated, found that more than 100 percent of the underperformance of value that occurred since 2007 was due to it becoming considerably cheaper relative to growth. In other words, all the outperformance of growth stocks was due to the change in what John Bogle called the “speculative return”—the change in valuations.
The evidence suggests that the period 2017-2020 was likely a repeat of the late 1990s. While no one knows what will happen from here, valuations do provide us with the best estimate. And they indicate we are likely to see a repeat of what followed when the dot-com bubble burst—the outperformance of value, from 2000 through 2007. During that period the Fama/French U.S. Small Value Research Index returned a cumulative 215 percent versus the cumulative return to the Fama/French U.S. Growth Research Index of 3 percent and the S&P 500 return of 14 percent.
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