The future long-term expected returns for value strategies are very promising. If history is a guide, current valuation levels imply that over the next five years, value stocks are poised to deliver an annualised excess return over the cap-weighted index of 1.2 per cent a year in Australia and 3.0 per cent a year in the US.
In other stock markets, the annualised expected excess returns over the next five years are bookended by those of the US and Australia: in the emerging markets, we expect a 2.8 per cent per annum excess return, in Europe 2.6 per cent per annum, and in the United Kingdom, a 2.1 per cent per annum excess return.
The gains in the US would come after the longest and deepest drawdown since 1963, during which value stocks underperformed their growth counterparts by 50.0 per cent since 2007. A daunting period for value investors. The falling relative valuations of large value stocks versus their growth counterparts over the last 13 years detracted 8.6 per cent from the value premium. Much of the value–growth valuation gap was fueled by very strong gains in the FAANG growth stocks – the big tech stocks – Facebook, Apple, Amazon.com, Netflix, and Google’s parent, Alphabet.
In Australia, over the same period value investing has done better. Over the last roughly 13 years, the Australian large value portfolio generated a 0.8 per cent annualised return, surpassing the Australian large growth portfolio, which fell by 0.5 per cent a year. That led to 1.2 per cent annualised outperformance of value versus growth in the post-2007 period in Australia. Growth underperformed value in both pre- and post-2007 periods.
If value were structurally impaired, we would expect value companies to underperform in Australia, as they have in the US, but this is not the case. Evidence of a value premium is well established and has a long history. Value is one of the most studied and academically recognised factors. The source of the value premium may be debatable, but a plethora of academic studies have consistently confirmed the value effect.
Expected returns are favourable for value investors
Against the backdrop of recent performance, should we expect value’s underperformance to persist? It’s unlikely. Over time, value stocks become relatively cheaper or more expensive compared to growth stocks as the two investment styles come in and out of favour.
When the value style is in favour, it attracts cash flows and new investment, returns are good as prices rise, and value becomes expensive based on relative valuation. When the market tide turns, the opposite happens: funds flow out of value stocks, these flows generate negative price pressure, and value becomes relatively cheap as returns fall. If this long-observed pattern holds, the falling relative valuation of value stocks versus growth stocks should be a temporary headwind and capital will eventually flow back to value stocks, boosting their performance.
We cannot dismiss the fact that returns are noisy. While the expected returns of value relative to growth are compelling, particularly in the US and emerging markets, the role of luck (both good and bad outliers not explained by the Research Affiliates model) creates a wide distribution of outcomes over shorter spans, even over the next five years.
Value strategies appear as attractive (if not more so) as they have ever been, but elevated expected returns are never a guarantee that value will outperform growth in the short run. This caveat aside, what we can say with greater assurance is that value is alive and well.
Mike Aked, director of research for Australia, Research Affiliates