When Cheap isn’t Cheap
4 MINUTES READING TIME
It is becoming increasingly difficult to find cheap stocks. This has serious implications for the future performance of value investing strategies. In the US, cheap stocks are arguably more expensive than they’ve ever been. The chart below is from Hussman Funds. It shows the S&P 500 ($SPX) split into deciles based on the price/sales ratio.
Notice the pattern? John Hussman explains.
Look at the valuation of each decile relative to its own history. As of last week, with the exception of the richest decile of stocks, where median valuations were higher only during the January 2000-March 2001 period (followed by median losses exceeding -80% for those stocks), every decile of S&P 500 components is currently at or within 2% of its most extreme valuation in history.
What happens to value strategies when cheap isn’t cheap?
It creates a significant headwind for value strategies. Let’s assume that we can buy the cheapest 20% of stocks (as measured by forward P/E ratio) for 7.6x. That’s a forward earnings yield of 13.2%. We can think of this as the return that we expect to earn from holding the cheapest 20% of $SPX stocks; assuming that consensus estimates are correct and valuations remain the same.
Adjusting this earnings yield gives us a rough but reasonable estimate of future returns. We can do this by considering the impact of each of the factors influencing the return of value investing strategies:
The majority of value stocks to lose money. We need to subtract the cost of these losers from the earnings yield.
There’s a small minority of very big winners that account for much of the value premium. We need to add back the gains from these winners, assuming that we’re lucky enough to own them (remember the odds are against us).
Future returns are determined by the size of the margin of safety and the time it takes to realize a profit. The valuation of cheap stocks as a group gives us a clue where the margin of safety for value stocks currently stands. Lower is better.
Value investing carries reinvestment risk due the need to trading and reinvest dividends. Higher (lower) valuations equal lower (higher) reinvestment risk.
Most value stocks make poor long-term investments as they are often suffer from poor profitability and a shortage of decent reinvestment opportunities. So, all other things being equal, we want to pay as low a price as possible for poor quality companies.
So our estimate of the returns to value investing are 13.2% plus or minus the impact of each of these factors.
But what happens if the forward P/E of the cheapest 20% of $SPX stocks increases to 10.8x? Our forward earnings yield drops by almost a third to 9.3%. What does this do the factors listed above? Its reasonable to expect that:
A higher overall valuation level probably increases the proportion of losing stocks as they now have further to fall.
The winners may not be as big since they’re starting form a valuation that’s approximately 30% higher.
Consequently, the negative performance impact of losers on overall portfolio returns is worse.
The margin of safety is smaller. Consequently, future returns are also lower.
Time pressure increases. In other words, investors need the margin of safety to close much faster if they hope to beat the market.
The need to trade more frequently (to get out of losers or realize winners) increases. Consequently, trading costs and taxes becomes more of an issue.
It’s harder to find new opportunities – increasing reinvestment risk.
Growth becomes more problematic as you’re paying more for low quality companies.
These comments apply to value stocks as a group. Of course, there will always be exceptions. Arguably, its the characteristics of the opportunity set that determine what we can reasonably expect. So if things get tougher for the opportunity set of value stocks, then its reasonable to expect that they also get tougher for investors following a value investing strategy.
The value investing mantra is to always look for a margin of safety. Shouldn’t this logic also apply to value investing as a strategy?
You might be wondering, where did my forward P/Es of 7.6x and 10.8x come from? They’re taken from an article by Stephen Gandel for Bloomberg Gadfly entitled Don’t Worry About Pricey Stocks. Worry About Cheap Ones.
The cheapest 20% of stocks in the $SPX traded on a forward P/E of 7.6 at the height of the tech bubble. In June, they were trading on a forward P/E of 10.8.
Expensive Value – A Global Problem
Is this just an issue for the $SPX? No, value stocks are expensive around the world as these charts from State Street Global Advisors Long-Term Smart Beta Forecasts show.
The chart above shows the median price-to-book spread for value as a factor (i.e. long cheap stocks/short expensive stocks) through time. The spread currently stands at one standard deviation below the long-term average.
The next chart shows what this means for future returns from value as a factor. They are likely to be low, assuming history is any guide.
Over the last six posts (including this one) we’ve considered what I think are the main challenges facing value investing strategies. Let’s assume that you agree with my analysis that the headwinds facing value investing strategies have gotten stronger. What should value investors do?