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ACM Journal - Investment Management
13 Jul

Value Stocks: Overdue? – Q2 2020 Newsletter

Making and saving money is hard. Perhaps that is why human beings are wired to look for bargains. We’re constantly looking for sales, coupons, rebates, and discounts. It feels better to know you didn’t overpay for something.

Interestingly, that isn’t always true in the stock market. There are investors who prefer to pay more for highly priced stocks in the hope that those stocks will rise even further. And, there are times when most of the market seems ready to overpay for the privilege of investing. Today is one of those times.

In the first half of this year, the largest, most expensive stocks have enjoyed the strongest performance. The top 10 stocks in the S&P 500 had a median market value of almost $850 billion. Those stocks traded at a median price-to-earnings ratio of 31. As a group they returned almost 10%. If you compare that with the smallest stocks in the S&P 500, their median market value was only $5 billion, and they traded at an ultra-low price-to-earnings ratio of less than 14. Those stocks lost almost 40% in the first half of the year.

It may seem crazy that the most overpriced stocks continue to become even more overpriced, but it isn’t unprecedented. The decade of the 1990s, when technology and internet stocks dominated the landscape, had a similar dynamic. These periods can go on for longer than we expect, but they do not last Ultimately, human nature takes over and bargain hunting begins again.

That may be why value stocks outperform over time. Value stocks are those that trade at lower prices relative to their intrinsic worth. That isn’t always easy to measure, but relative to the overall market or to growth stocks, value stocks as a group can be clearly defined. They are the stocks that trade most cheaply to their earnings, sales, cash flows, and book values.

Value stocks have had a tough go of it lately, but the future looks much brighter. They currently trade at the biggest valuation discount to growth stocks ever, even larger than during the 1990s technology bubble. Historically, these disparities have been an opportunity for long-term investors to profit in the years ahead. Coming off such lows, value stocks tend to provide outsized returns that last for many years. That was true in the wake of the tech boom, as large-cap growth stocks lost money during the decade of the 2000s, while value stocks provided positive returns.

The problem is, there is no free lunch in the world of finance. The excess returns that value stocks have provided also come with a higher level of risk. That isn’t always visible in traditional statistical analysis, but when markets turn down and liquidity dries up, value stocks often show their true risk profile. That was true this year as well. Value stocks fell much more than the market during March and April. They have rebounded some, but still remain significantly off their highs, whereas the overall stock market is only down a little from its high point last February.

That risk/reward profile means that value stocks aren’t for everyone, and they probably shouldn’t comprise your entire portfolio. However, as part of a diversified portfolio, they can make a lot of sense. We’ve been invested in value stocks since the inception of our firm, and we plan to continue holding them for the long haul. That can make for some uncomfortable periods (see year-to-date returns), but over time should result in larger portfolios.

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