IS SMALL CAP-VALUE DEAD?
While over the long-term small value stocks have outperformed large growth stocks, the underperformance of small-cap value stocks relative to large growth over the past ten years has received much attention from the financial media. For example, using data from Morningstar, Avantis found that from 2010 through July 2021, large growth stocks returned 492 percent versus just 181 percent for small value stocks. That gap has led some investors to conclude that small-cap value investing is dead. Are they right, or are they premature in their belief? To help answer the question, we will examine what has driven the outperformance of large growth.
When I ask investors why they believe large growth has outperformed, the answer typically revolves around the notion that “this time it’s different” because technology is moving faster than ever and network effects lead to large growth outperforming even more. As a result, large growth company earnings have been rising much faster. I point out that expected faster growth in earnings is an insufficient reason to believe that large growth stocks will outperform because higher expected earnings growth is already built into prices. Thus, the differential in earnings growth needs to be greater than was already expected to get that outperformance.
While it is true that earnings of large growth stocks have grown faster than earnings of small-cap value stocks — Avantis estimated that large growth earnings grew by approximately 194 percent between January 2010 and July 2021 versus an earnings increase of 177 percent for small value stocks — the differential was less than 2 percent per year. That differential is a lot smaller than what would have been the expected differential, and certainly cannot explain the fact that the return to large growth stocks was 492 percent versus the 181 percent return to small value stocks over that same period.
In fact, I would suggest that if investors had known the growth in earnings of large growth stocks would be only 2 percent per year greater than those of small value stocks, investors would have expected small value stocks to far outperform because the earnings growth of large growth stocks would have been well below expectations. Data from Avantis shows that the P/E of the Russell 1000 Growth Index was 18.4 at the end of 2009 versus just 13.3 for the Russell 2000 Value Index — the higher valuations of large growth stocks were due to the much higher expected earnings growth, and that rate of growth never happened!
Changes in valuations explain the performance gap
While returns to small-cap value stocks (181 percent) were virtually in line with their earnings growth (177 percent), the 492 percent return to large growth stocks was 298 percentage points greater than their earnings growth (194 percent). In other words, the outperformance of large growth stocks cannot be explained by earnings performance. Instead, the outperformance is fully explained by a change in valuations — the price investors are willing to pay for a dollar of earnings, which John Bogle called the “speculative return.” That price increased dramatically (more than 50 percentage points) for large growth stocks but remained virtually unchanged for small value stocks (see Figure 3 in the Avantis monthly report). For example, Morningstar reports that as of June 30, 2021, the P/E ratio of the largest large growth ETF (VUG) was 32.9, while the P/E ratio of the largest small value ETF (VBR) was just 14.1. Research has shown a relationship between valuation ratios and future returns.
Adam Zaremba and Mehmet Umutlu, authors of the March 2019 study Strategies Can Be Expensive Too! The Value Spread and Asset Allocation in Global Equity Markets, examined whether the value spread (the difference in valuation ratios between the long and the short sides of the trade) was useful for forecasting returns on quantitative equity strategies for country selection. To test this, they examined a sample of 120 country-level equity strategies replicated within 72 stock markets for the years 1996 through 2017.
They found: “The breadth of the value spread can predict the future returns in the cross-section. We show that equity strategies with a wide value spread markedly outperform strategies with a narrow value spread. In other words, if you wonder which strategy might produce decent payoffs in the future, pay attention to the value spread.”
Their findings are consistent with prior research. For example, the February 2018 study Value Timing: Risk and Return Across Asset Classes by Fahiz Baba Yara, Martijn Boons and Andrea Tamoni also found that valuation spreads provide information. The authors demonstrated that “returns to value strategies in individual equities, commodities, currencies, global government bonds and stock indexes are predictable by the value spread. … In all asset classes, a standard deviation increase in the value spread predicts an increase in expected value return in the same order of magnitude (or more) as the unconditional value premium.”
In his 2007 study, Does Predicting the Value Premium Earn Abnormal Returns?, Dimensional’s Jim Davis also found that book-to-market ratio spreads contain information regarding future returns. However, he also found that style-timing rules did not generate high average returns because the signals are “too noisy” — they don’t provide enough information to offer a profitable timing signal.
The bottom line is that because differences between valuation ratios of growth and value stocks are at historically very high levels, we should expect the value premium going forward to be higher than average.
Unfortunately, while this link between valuation ratios is informative, the information is not strong enough to provide any timing clues to act on it. Despite this disappointing fact, it is interesting to look at valuation ratios and think about long-term expectations given current security prices.
Current large-cap growth P/E ratios are higher than they have been over the last ten years and are similar to the ratios of the early 2000s, just before that “bubble” burst. On the other hand, small-cap value ratios have not changed as significantly over the same period.
While small-cap value stocks have outperformed recently, from a valuation perspective they are still trading much closer to long-term averages than growth stocks (particularly large caps), which is an indication of their expected returns. So no, small-cap value investing isn’t dead.
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