6 Reasons Not To Give Up On Value

12/28/2015


In some corners of Wall Street, 2015 is being written up as the year that value investing died as a viable strategy. All these obituaries mention this year's miserable returns for value portfolios of nearly all stripes, and most point to the extended losing streak of value based on its most long-lived formulations.

Based on data maintained by Dartmouth's Kenneth French, the cheapest U.S. stocks have lagged their more expensive counterparts by 2.6% annually since February 2007 — the longest such losing streak since his data begin in 1926. The Russell 1000 Value Index, one of the most prominent value benchmarks, has now underperformed the Russell 1000 Growth Index over the past one, three, five, and 10 years.

While it is impossible to predict when value will regain its edge, writing it off as a viable strategy is a mistake. For at least six reasons, we think reports of value's death have been greatly exaggerated.

• First, the data maintained by French uses the price/book value ratio to separate value and growth stocks. Academics like using book value — a company's assets minus its liabilities — because it is relatively stable and unlikely to be negative. And most of the time since 1926, stocks cheap based on price/book performed in line with those cheap based on price/earnings and other valuation ratios. But that has not been the case over the past 10 years, as stocks cheap on price/book have underperformed relative to stocks cheap on such measures as price/free-cash-flow, price/sales and enterprise value/EBITDA.

• Second, databases like those of French typically categorize most stocks as either growth or value, meaning many stocks with only slightly below-average valuations end up in the value camp. By comparison, we typically look at the cheapest 20% of stocks when evaluating valuation ratios used in our Quadrix stock-rating system. On that methodology, even price/book has delivered modest outperformance over the last decade, with the cheapest 20% outperforming by 0.9% on average in rolling 12-month periods.

• Third, the Russell 1000 Value Index is not the best proxy for value investing. To select its holdings, the index scores stocks based on price/book value and expected long-term profit growth. Those with relatively low price/book ratios and expected growth rates are put in the value camp. While that makes some sense in terms of style purity, it does not seem like a great way to invest. Why not emphasize stocks with the cheapest valuations and highest expected growth rates, like we do with our Quadrix Overall score?

• Fourth, long streaks of underperformance — and outperformance — are not unusual with value stocks. The chart on page 4 shows the relative performance of the top one-fifth of stocks based on our Quadrix Value score, which is based on about 20 different valuation ratios. As shown, the top one-fifth on Value have outperformed the average stock in 59% of the 275 rolling 12-month periods since 1993. But the Value score has suffered a few extended losing streaks, with especially poor relative returns in the tech bubble of the late 1990s. After that slump and another one from 2007 to early 2009, value stocks bounced back with strong relative returns.

• Fifth, nothing says value variables must be used in isolation. In our view, value variables work best in combination with other stock-picking metrics, such as recent profit growth, earnings-estimate revisions, and share-price performance. In calculating our Quadrix Overall score, we use a weighted average of our six category scores. Value receives the biggest weight, yet our Overall score has delivered decent outperformance over the past one and five years.

• Sixth, we see some attractive opportunities among value standouts with solid growth prospects. Apple ($109; AAPL), Gilead Sciences ($103; GILD), Jabil Circuit ($24; JBL), Lear ($126; LEA), and Southwest Airlines ($43; LUV) rank among the cheapest one-fifth of stocks based on Quadrix Value scores. All five stocks also rank among the top one-tenth of stocks on Quadrix Momentum scores and earn Overall scores of at least 97.

Beyond price/book: Returns of selected value variables
------------- Average 12-Month Outperformance Of Highest One-Fifth Of Scorers In Broad Dow Jones U.S. Index Based On -------------
Quadrix Scores
Overall
(%)
Value
(%)
Price/
Free
Cash
Flow
(%)
Price/
Sales
(%)
Enterprise
Value/
EBITDA
(%)
Price/
Sales
To 5-
Year
Median
(%)
Price/
Earnings
(%)
Price/
Book
Value
(%)
Price/
Cash
Flow
(%)

P/E To
5-Yr.
Median
(%)

Price/
Cash
Flow
To 5-Year
Median
(%)
Price/
Book
To 5-Year
Median
(%)
Div.
Yield
(%)
Since Jan. 1992
2.6
3.4
4.2
4.2
4.1
3.3
3.3
3.1
2.9
2.0
1.4
1.2
0.1
Last 10 years
0.4
1.7
2.2
4.4
2.7
1.4
1.1
0.9
2.4
2.2
0.7
0.7
(0.8)
Last 5 years
1.6
0.4
2.0
1.5
0.2
(3.2)
(0.3)
(1.7)
(0.7)
(0.5)
(2.6)
(2.9)
(0.2)
Last 1 year
1.1
(3.9)
3.2
(0.3)
(5.1)
(8.4)
(3.8)
(5.0)
(5.2)
(2.5)
(7.2)
(6.8)
1.7

With the exception of the price/free-cash-flow-ratio, the 12 months ended Nov. 30 were tough for nearly all the variables used in our Quadrix Value score.

Based on the price/book value ratio, used in many academic studies, the cheapest one-fifth of stocks underperformed over the past five years and outperformed only modestly over the past 10 years. But the Value score, based on about 20 different valuation ratios, has performed much better.

Compared to price/book, the Value score has also delivered less volatile relative returns since 1992. But other Value variables — notably the standouts of price/free-cash-flow and enterprise value/EBITDA — have delivered higher returns with less volatility than the Value score.


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