In 2020, after two years of underperformance, valuations of value stocks across all major regions and sectors fell to levels as cheap relative to their growth sector peers as they were at the peak of the 2000 Tech Bubble.
In 2021, value finally started outperforming growth. However, this has so far done little to reduce the spread in valuations. The inflationary consequences of recent geopolitical developments, which raise the prospect of central banks increasing interest rates significantly, contribute to an outlook that we see as distinctly more favourable to value than growth stocks.
The value spread and premium
By definition, value stocks trade at lower prices relative to their fundamental values, while glamour stocks – growth stocks with higher expected earnings or sales growth – trade at high valuations.
The gap between the valuations of these two types of stock is known as the value spread.
The value premium is the excess return of cheap stocks relative to glamour stocks. As we explain in our most recent academic paper, this is both larger and significantly more persistent when measured in sector-neutral terms, i.e. comparing apples with apples by measuring the returns of stocks in a single sector relative to those of their sector peers.
In the paper, we show how the sector-neutral value premium arises naturally from the convergence of value stocks’ cheap prices and growth stocks’ expensive prices towards their respective fundamental values. We illustrate how periods of value spread compression are more favourable for value stocks and, conversely, that periods of value spread expansion tend to favour growth stocks.
Finally, we show that the underperformance of value stocks in 2019 and 2020 could be explained by a rapid expansion in value spreads in all sectors and regions.
Value spreads were expected to peak in 2021
About a year ago, we argued that the end of 2020 marked a secular reversal for the value spread after more than 10 years. Back then, we observed that the spread had expanded in 2018-2020 to record highs in every sector and region, much as it did between 1998 and 2000 during the Tech Bubble.
As we predicted, 2021 was favourable for value stocks: they outperformed in most regions and sectors. We thus thought it worth looking into whether the impact of that outperformance translated into a significant compression in value spreads.
In fact, value spreads peaked in all regions, but remain wide
Exhibit 1 presents an update of the composite sector-neutral value spread for stocks in the MSCI World index, following the same approach introduced in last year’s post. We show the periods of expansion and compression of value spreads and the aggregate excess returns of value stocks from five macro sectors relative to their peer growth stocks.
It is clear that the value spreads did not compress by much despite the outperformance of value over growth in 2021.
Exhibit 1: Normalised composite value spread for stocks in the MSCI World index since 2000 and a reconstruction of its universe before (lhs) and the aggregate excess returns of value stocks relative to their peer growth stocks (rhs)
The value strategy is macro-sector and beta neutral and based on a target volatility approach. Five macro sectors were used. A diversified set of value factors, as described in our article, was used to measure stock valuations. Source: Bloomberg, FactSet, Worldscope, IBES, Exshare-ICE, BNP Paribas Asset Management. For illustration purposes only.
Value spreads remain significant in all macro sectors
The trend toward compression is also the same when looking at macro sectors. As Exhibit 2 shows, the value spreads of those sectors that fared better during the Covid-19 crisis, i.e., information technology & communication services and defensive macro-sectors such as consumer staples, healthcare and utilities, peaked in early 2021 at similar or higher levels compared to those seen at the peak of the Tech Bubble.
Exhibit 2: Normalised composite value spread for stocks in MSCI World macro sectors: IT & communications services, defensive (consumer staples, healthcare, utilities)
Based on a reconstruction of the MSCI stock universe before 2000. Source: Bloomberg, FactSet, Worldscope, IBES, Exshare-ICE, BNP Paribas Asset Management. For illustration purposes only.
Environment should favour value stocks and multi-factor equity strategies
We argued in our recent research that spread expansion explained the poor performance of sector-neutral value strategies and sector-neutral multi-factor equity strategies in 2019 and 2020.
If 2019-2020 resembled 1998-2000, a prolonged multi-year period of compressing spreads remains the most likely scenario. Our latest update shows that such a compression, which may have started in 2021 in all regions and macro sectors, has so far been quite modest.
Moreover, what was already a favourable value investing scenario may even be reinforced by the manifest intention among leading central banks to respond to rising inflation by raising official interest rates. Such a scenario is typically unfavourable for growth stocks.
When it comes to performance, sector-neutral value strategies and multi-factor strategies recorded a strong rebound in 2021 as value spreads peaked. Other factor styles such as quality, momentum and low risk also did well, as shown in Exhibit 3.
In our view, since value spreads still have a long way to compress, the environment remains particularly favourable for value and multi-factor equity strategies.
Exhibit 3: Historical factor and multi-factor performance. Factors are macro sector and beta neutral and based on a target volatility approach, with each style based on a diversified set of factors as described in our article
Based on monthly net returns in USD for MSCI World index. Rebalanced monthly. No transaction costs or management fees. Source: Bloomberg, FactSet, Worldscope, IBES, Exshare-ICE, BNP Paribas Asset Management. For illustration purposes only.
Further reading on value investing
Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. The views expressed in this podcast do not in any way constitute investment advice.
The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.
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