Swedroe: Small Value Lags For 15 Years

February 20, 2019

The bottom line is, while investors in U.S. small value stocks may have been disappointed by their performance over the past 15 years, given that non-U.S. stocks make up about 50% of global market capitalization, a globally diversified portfolio weighted to small value stocks would still have outperformed a total market approach and would have done so despite their higher implementation costs. And they did—over a period that was one of the worst we have experienced for small value stocks.

Before closing, there’s one other point we need to cover: Has publication killed the premiums in value stocks?

Valuations Matter

I kept a table from a seminar given by Dimensional in 2000. It shows that at the end of 1994, the price-to-book (P/B) ratio of U.S. large growth stocks was 2.1 times higher than the P/B ratio of large value stocks. Using Morningstar data, as of November 26, 2018, the iShares S&P 500 Growth ETF (IVW) had a P/B ratio of 4.9, and the iShares S&P 500 Value ETF (IVE) had a P/B ratio of just 2.0—the spread has actually widened from 2.1 to 2.5. Thus, according to that metric, value stocks are cheaper today, relative to growth stocks, than they were shortly after Fama and French published their famous research. In other words, the ex-ante value premium is now larger, not dead.

We can also look at the price-earnings (P/E) metric. In 1994, according to the Dimensional table, the ratio of the P/E in large growth stocks relative to the P/E in large value stocks was 1.5. As of November 26, 2018, and again using Morningstar data, IVW had a P/E ratio of 19.9 and IVE had a P/E ratio 14.0. Thus, the ratio, at 1.4, was just slightly lower. There’s no evidence here that publication, popularity and cash flows have eliminated the premium.

We see similar results when we look at U.S. small stocks. The Dimensional data shows that at the end of 1994, the P/B of the CRSP 9-10 (microcaps) was 1.5 times larger than the P/B of small value stocks. Using Morningstar data, and Dimensional’s microcap fund (DFSCX) for microcaps and its small value fund (DFSVX) for small value stocks, as of September 30, 2018, the ratio of the funds’ respective P/B metrics was the same 1.5 (1.9÷1.3). When we look at P/E, again the results are similar. At the end of 1994, the ratio of those funds’ respective P/E metrics was 1.2; it has actually widened slightly to 1.3 (17.1÷13.4). Again, I see no evidence that publication, popularity and cash flows have eliminated the premium.

Using data from Ken French’s website, we also see similar results when we look at the period starting in 2008. In 2008, the ratio of the P/B of U.S. growth stocks (4.8) to U.S. value stocks (1.1) was 4.4. By the end of 2017, the ratio had increased to 5.3 (6.3÷1.2), the opposite of what you would expect if cash flows had eliminated the premium.

Summary

Based on the logical, risk-based explanations for the small value premium, as well as the behavioral-based explanations for it, and the lack of evidence pointing to shrinking valuation spreads, the conclusion you should draw is that the most recent 15 years of performance in the U.S. is likely just another of those occasionally occurring, but fairly long, periods in which stocks with historical premiums underperform. As mentioned above, if such periods did not occur, there would be no risk, and no risk premium.

 

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.

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