Value Stocks are in the Eye of the Beholder
It’s February — the month of love! Valentine’s Day is just around the corner and people all over the country will be giving and getting gifts, flowers, candy, etc. When I hear talk of love in the equity markets, there’s only one type of investment that comes to mind – value stocks.
People LOVE value stocks. Warren Buffet loves them, Mario Gabelli loves them, Seth Klarman loves them and ardent followers of the Fama-French Three Factor Model are infatuated with them. Truth be told, I love them too and I own value stocks in my retirement account via exchange-traded funds (ETFs) and DFA funds.
Like all things concerning love, however, value is in the eye of the beholder. What you cherish in a value stock may not be what appeals to some else. You may like companies with a high earnings-to-price ratio (high E/P) while other folks go for high dividend paying stocks (high Div$). Many famed money managers tend to fall for high cashflow companies that have low prices (high CF/P). Famed academics Gene Fama and Ken French enjoy the stability of book value and this leads them to high book-to-market companies (high BtM).
Most index providers don’t have a preference for one value factor over another. They play the field with a multi-factor approach that blends various value indicators together. Morningstar, Dow Jones S&P, Russell, and Wilshire are playboys in the value market.
It’s okay to love a particular value style or enjoy multiple styles because in the long-term, all value strategies tend to outperform the stock market, albeit with more risk. Fama and French do not believe the excess return from value investing is not without consequence. We all remember how poorly bank stocks performed during the financial crisis, and who can forget Lehman Brothers.
It’s also worth noting that different value styles don’t perform the same over any given period of time. Figure 1 illustrates the variation in three-year relative return performance of four value and growth strategies. The data set for Figure 1 was derived from the Ken French Data Library.
Four different fundamental factors are used for comparison in Figure 1: . I used trailing three-year calendar returns for the various factors ending in 2012. Stocks were grouped based on of the four factors using the upper and lower 30 percent bands. The middle 40 percent was left out. Value stocks had lowest prices relative to earnings, cash-flow and book value and the highest cash dividends. Growth stocks had the highest prices relative to earnings, cash-flow and book value as well as the lowest cash dividends.
Figure 1: Excess Style Returns Relative to the Market: Three-Years Ending 2012
Source: Ken French Data Library
Figure 1 show that high cash dividend paying (Div$) was the best value strategy over the last three years. It outperformed the market by 3.6 percent annually. High dividend paying stocks were hot as investors scrambled for income after the 10-year Treasury bond yield fell below 2.0 percent.
High book-to-market (BtM) was the worst performing strategy since 2010. It had a negative 1.7 percent relative return compared to the stock market. Fama and French fetishes didn’t pay.
On the growth stock side, low earnings-to-price (E/P) was the best returning strategy with a 2.9 percent annualized excess return. Not surprisingly, low dividend paying stocks (Div$) failed to spark any interest in the low interest rate environment and was the worst performing growth strategy.
Before running out and courting high dividend yielding stocks, consider Figure 2. It highlights the calendar year returns of the four value factors since 2008. High dividend paying stocks had strong calendar year returns in 2010 and 2011 as investors rushed in looking for yield. However, the style lagged among the four value factors in 2012.
Figure 2: Value Factor Calendar Year Returns
Source: Ken French Data Library
Fama and French’s high book-to-market (High BtM) stocks performed the best among the value plays in 2012. Companies with high earnings-to-price (High E/) came in a respectable second. High dividend paying stocks underperformed all other value factors and also unperformed the market (not shown).
This isn’t a message to dividend investors that the party is over. I have no idea if high dividend stocks will outperform in the future or not. It’s just a reminder that every stock strategy works sometimes, but none of them work all the time.
No one can say which value factor will win the market’s heart this year or over the next ten years. If you love a particular value strategy, then stick with it for the long-term and you’ll be happy that you did. If you’re prone to spread your love around, then a multi-factor strategy may be right for you. Or, perhaps you a loner and don’t care about value stock love at all. In the long run, it all works as long as you remain committed to your beliefs.
Happy Valentine’s Day!