Swedroe: Value Down But Not Out

April 04, 2018

As the director of research for Buckingham Strategic Wealth and The BAM Alliance, I’ve been getting lots of questions about whether the value premium still exists. Today I’ll share my thoughts on that issue. I’ll begin by explaining why I have been receiving such inquiries.

Recency bias—the tendency to give too much weight to recent experience and ignore long-term historical evidence—underlies many common investor mistakes. It’s particularly dangerous because it causes investors to buy after periods of strong performance (when valuations are high and expected returns low) and sell after periods of poor performance (when valuations are low and expected returns high).

Value Premium Fading?

A great example of the recency problem involves the performance of value stocks (another good example would be the performance of emerging market stocks). Using factor data from Dimensional Fund Advisors (DFA), for the 10 years from 2007 through 2017, the value premium (the annual average difference in returns between value stocks and growth stocks) was -2.3%. Value stocks’ cumulative underperformance for the period was 23%. Results of this sort often lead to selling.

Investors who know their financial history understand that this type of what we might call “regime change” is to be expected. In fact, even though the value premium has been quite large and persistent over the long term, it’s been highly volatile. According to DFA data, the annual standard deviation of the premium, at 12.9%, is 2.6 times the size of the 4.8% annual premium itself (for the period 1927 through 2017).

As further evidence, the value premium has been negative in 37% of years since 1926. Even over five- and 10-year periods, it has been negative 22% and 14% of the time, respectively. Thus, periods of underperformance, such as the one we’ve seen recently, should not come as any surprise. Rather, they should be anticipated, because periods of underperformance occur in every risky asset class and factor. The only thing we don’t know is when they will pop up.

However, a long period of underperformance should not cause investors to abandon a well-developed plan. Nor should it cause them to question the existence of the value premium any more than it should have caused them to question the existence of the market beta premium when DFA data shows it turned negative for 3% of the 20-year periods from 1927 through 2017. That’s not all too different than the 6% of 20-year periods that the value premium was negative during that time.

Don’t Give Up On Value

As I’ve discussed before, there are several reasons investors should continue to expect an ex-ante value premium. The first is that risk cannot be arbitraged away, and the research offers many simple and intuitive risk-based explanations for the persistence of the value premium.

Second, if—as many people believe—the publication of findings on the value premium has led to cash flows that have caused it to disappear, we should have seen massive outperformance in value stocks as investors purchased those equities and sold growth stocks. Yet the last 11 years have witnessed the reverse in terms of performance.

Third, academic research has found that valuation metrics, such as the earnings yield (E/P) or the CAPE 10 earnings yield, and valuation spreads have predictive value in terms of future returns. In other words, the higher the earnings yield, the higher the expected return, and the larger the spread in valuations between growth and value stocks, the larger the future value premium is likely to be. What’s more, this relationship holds across asset classes, not just for stocks.

 

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