The prolonged underperformance of value stocks relative to the market may be explained as a slowing of long-term market profitability trends, according to a portfolio manager and analyst with Invesco.
The prolonged underperformance of value stocks relative to the market may be explained as a slowing of long-term market profitability trends, according to a portfolio manager and analyst with Invesco.
The two found a widening gap between the profitability—as measured by return on equity (ROE)—of the cheapest and the most expensive stocks.
The study broke the period between 1991 and 2019 in half to see what happened to the ROE of large-cap value and glamour stocks over time. A noticeable slowdown in mean reversion—the tendency for individual companies’ profitability to return to the average—was observed.
Mean reversion in ROE has historically occurred when market segments with abnormally high profitability attracted competition. Eventually profitability decreased. Segments with low profitability either experienced a period of poor cyclicality or adapted to survive, while failing companies fell away, causing an improvement in profitability.
Looking at U.S. large-cap stocks, the median ROE of the most expensive stocks was consistently higher while the median ROE of the cheapest stocks was consistently lower. Since value stocks have low ROE, they should as a group exhibit a trend of improving ROE while glamor stocks’ ROE deteriorated.
However, the mean reversion rate of value stocks in the second half of the period studied—between 2005 and 2019—decreased when compared to the mean reversion rate between 1991 and 2004. Value stocks with low ROE did not see their performance improve over time as expected. The authors believe this decrease in mean reversion for value stocks has potentially led to fewer earnings surprises, accounting for the underperformance of value stocks. The increasing ROE gap between value and glamour stocks is now especially exaggerated, the authors note. This gap is increasing as the mean reversions for both groups are slowing.
The authors of the study began by questioning the definition of a value stock—popularized by famous economists Eugene Fama and Kenneth French—as stocks with a low price-to-book-value ratio. The underperformance of value stocks based on this definition is tied to the market undervaluing a stock based on a measure of its equity capital. Underestimating the growth potential of a stock by the market then leads to earnings surprises that increase performance and track with a value stock’s mean reversion.
Source: “Searching for Inner Peace With Value Factors,” by Yifei Shea and Erhard Radatz; Risk & Reward, 2020.
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Russell H from IL posted over 5 years ago:
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