Models Now Suggest This Factor Could Beat The Market By 8% A Year

Models suggest value may be set to outperform the broader market.Growth has seen a strong run, but it may prove hard to sustain in the coming years.

Valuation Gap

The relative valuation gap between value and the broader market is now wide and growth looks expensive in a similar way. Of course, growth stocks often by definition, more expensive than value anyway. If we adjust for that, the spread remains very wide. It’s below the 10th percentile on historical analysis. At the start of this run of growth outperformance, growth stocks traded at around double the valuations (based on book value) of value stocks. Now that valuation gap has expanded around four to five times. Arguably, book valuations are less useful than they used to be, because companies have become less capital intensive. Also maybe investors are getting better at using these simple metrics. Still, the valuation gap is wide. Looking at dividend yields, the Russell 1000 growth index yields 0.6%, the value equivalent yield closer to 3%. And the Russell 1000 growth trades at 38x earnings while value trades at 15x. These are wide gaps. The rates at which growth stocks will have to grow earnings compared to value stocks could be extremely demanding if valuations stay the same, let alone if the the growth premium expands. This analysis is also somewhat robust to the precise value signal you use, for example high dividend yield and fundamentally weighted strategies appear well-positioned today too.

Factor Models

Research Affiliates share a set of factor models that they call Smart Beta Interactive. Value currently offers the prospect of the highest estimated return on a 5-year view as of the end of June. That’s not a unique view, many researchers looking at value factors based on history reach a similar conclusion.

Now, it’s not all plain sailing, tracking error is expected to be high as well, meaning that the performance of value could be volatile, for example, value has started to look attractive in recent years, but hasn’t fully delivered. If value were to outpace growth that would be something we haven’t seen for a while, as value investors have been beaten by growth investors in recent years. Also, remember that relative performance can be misleading. If value does indeed beat the market by 8%, but the market falls 10% then you still end up losing money in value, albeit maybe less than you would with other strategies. However, value outperforming the market by 8% for 5 years is possible. Growth has outperformed value by about 7% a year for a decade now. So that sort of relative performance is posssible.

Limits To Growth

Separately, one may also ask how value large growth stocks, which increasingly dominate indices such as the S&P 500 can really go. For example, Apple , which appears a growth stock based on its valuation, was earlier this month worth more than the top 100 stocks in the U.K. though its fallen back since. As another example, Microsoft’s valuation exceeds that of the U.S. energy sector. When single growth stocks start to dwarf major indices and sectors, valuations may be getting stretched. These companies are not invincible. Though many are well-managed currently, for example, Apple almost went bust 22 year ago. By the same token the future may not be as certain as it appears to growth investors. Issues from regulation to taxation to technological shifts could weigh on today’s major growth names in the coming years.

So growth has had a great decade. The evidence is mounting that value will likely enjoy a comeback, just as it has in previous eras. The catch is, of course, we don’t know when, and the gap between value and growth has persisted longer than many anticipated. Still, the setup for value in the U.S. is attractive compared to much of history.

Caveats

There are plenty of strong value investors around, and also many great growth investors. In contrast, there aren’t too many people sitting on piles of wealth due to this sort of market timing. Many who believe in factor investing, also believe that timing those same factors can be counterproductive. Also, even, if correct, most models are just showing relative outperformance for value. So even should that come to pass you may not make money from value stocks should it coincide with a bear market. Simply put, growth stocks falling heavily could close the gap, rather than value stocks rising. That outcome would be less pleasant for most investors.