Why doesn’t Everyone Benefit from the Value Premium?

March 31, 2015 — Leave a comment

It is well established that value stocks (stocks with low price/book value, or price relative to the company’s liquidation value) earn a higher return than the general market. The effect is very meaningful – potentially 2% excess annualized return. It was tested through long time periods, retested through new periods, and retested in many different countries (out of sample testing). It is also logical – if the price is low relative to the value of the company assets, it has room to grow to reach the valuations (P/B) of other companies.

So, why doesn’t everyone focus on owning them? Value stocks tend to be less known and less glamorous. They often have low price relative to their book value as a result of poor recent returns. People like to see that the stock “proved itself” before investing in it. They also like to imitate others’ success. To make matters much worse, value stocks don’t always do better. They can do worse for long stretches of 5+ years. I have seen people think logically about investments, and stick through tough periods. But, as the period gets longer, they lose faith in the long-term success.

A strong example from recent years is Emerging Markets Value. This asset class suffered in multiple ways – both emerging markets and value suffered poor performance for the past 5 years. To add insult to injury, the more known US market had unusually high returns. This led people to think that the US is a better investment and to sell from emerging markets to buy US investments.

US stocks reached high valuations (P/B), and emerging markets reached low valuations (P/B). The relative valuations between the S&P 500 and emerging markets value almost doubled in the past 5 years. Your emerging markets investments would not reach the S&P 500’s P/B, until they approximately triple in value – that is about 200% gain. An observation of the past 17 years of emerging markets value returns, shows how surges emerge from low valuations. Here are distinct 12-month periods with ~100% gains in this timeframe:

Period starting at 12-month return
9/1998 120%
4/2003 97%
3/2009 117%

These returns occurred approximately every 6 years. The value premium is greatest when having big gains that stem from low valuations. For example, in the recent 2009 surge, emerging markets value outperformed the general emerging markets by more than 20%.

What is the logic for these surges? As explained above, the past selling results in poor performance, leading for more people to sell, and propagates the poor returns. This is a snowball that can go on for a while. As valuations reach very low points, any bit of marginally good news can lead to a surge – whether it is a reduction in interest rates, government spending, or economic results that are not bad enough to justify the very low valuations.

Your strong value tilt means that you buy the unloved companies that people sell. When people are completely desperate and lose all faith in these companies, you buy low, and when the turnaround comes, you reap the greatest benefits – life changing benefits. This focus on value stocks is one big thing you have in common with Warren Buffett, one of the greatest investors of all times.

Disclosures Including Backtested Performance Data

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Gil Hanoch

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