When Valuation Fails

A relative valuation discipline lies at the core of our tactical asset allocation (TAA) process. We seek to overweight cheap asset classes and underweight expensive ones.??

This strategy sounds simple, but it’s not. There are two big challenges:?

1. It isn’t easy to catch turning points. “To unlock a valuation advantage, you need a catalyst,” said my colleague Charles Shriver, portfolio manager and cochair of the Asset Allocation Committee. That’s why our process incorporates fundamental, macroeconomic, and sentiment factors.??
2. Secular changes can create "value traps”. For the last 20 years, the relative valuation of value stocks has trended down, as shown below. Relative to growth stocks, value stocks have gotten cheaper and cheaper... and cheaper. For investors who seek to make money from relative valuations reverting to the mean—which historically has tended to work over time and across asset class pairs1—that’s about as disheartening a chart as I’ve ever seen.??

What has created this mother of all value traps? In one word, technology.??

In more words:?

• Corporate business models have shifted from investing in hard assets (property, plant, and equipment) to intangibles (Research & Development).2
• The breakthroughs from intangible investments have been highly disruptive to legacy business models.?

“You need to incorporate innovation into classic macroeconomic theory. If the pace of innovation is increasing, it’s easier to be in growth stocks,” said a committee member.?

• Accounting practices have failed to adapt to this shift. According to Lev and Srivastava (2002),2 growth companies—especially tech companies—that invest in intangibles have looked increasingly expensive due to decreases in three important metrics:

○ Book values: “A firm investing heavily in R&D, IT, brands, or business processes (e.g., customer recommendation algorithms), may appear to be an overvalued company... whereas in reality its valuation isn’t excessively high when book value is properly measured.”?

○ Earnings: “Reported earnings of companies with increasing investments in intangibles are understated, due to the immediate expensing of intangibles, leading to overstated P/E ratios.”?

○ Cash flows: “Cash flows [are also] calculated after the deduction of intangibles, and therefore, do not solve the accounting-deficiency discussed above.”?

To be clear, it’s not just the fault of accountants. Like relative valuations, fundamentals have trended rather than mean-reverted. The following chart shows that profitability, as measured by return-on-equity (ROE), has steadily improved for growth relative to value stocks. As my colleague Peter Stournaras, head of Integrated Equity at T. Rowe Price, puts it:?

“Value has underperformed because platform companies operating in a digital world have demonstrated sustained and exceptional growth.”??

A corollary is that the value premium disappeared at the security level. Figure 3 shows three versions of the value premium based on historical rolling 20-year periods. Each line represents the hypothetical results of a long-short academic exercise that bought the third cheapest stocks and sold the third most expensive stocks based on book-to-price (B/P), earnings yield (E/P), or cash flow to price (CF/P). Stocks are re-ranked and rebalanced once per year. The lines are shorter for E/P and CF/P because of data limitations.?

While it was positive for most of history, the average value premium was -1.4% over the last 20 years.3??

By the standards of money management careers, 20 years is an eternity. Most clients evaluate portfolio managers over 1-, 3-, 5-, and 10-year periods. As Lev and Srivastava note, “A Google search of the ‘death of value investing’ and related morbid terms yields hundreds of articles, including in Forbes, Barron [sic], The Wall Street Journal, Seeking Alpha, Bloomberg, and [the] Financial Times.”2?

Chandrashekaran (2021) asks rhetorically whether value factors are “the hill that quants may die on?”??

While some have thrown their hands in the air and declared that “fundamentals don’t work” or “markets are broken,” skilled stock pickers have adapted by:??

• Doubling down on fundamental research, company by company,??
• Adjusting accounting data to reflect the value of intangible assets,?
• Positioning portfolios to take advantage of disruptive change.?

Skilled asset allocators have adapted, as well. We’ve had to. Figure 4 below shows the hypothetical rolling performance of a na?ve tactical exercise that overweights value or growth stocks based on relative valuation opportunities. Cesare Buiatti tested various trading rules to generate a data-mining confidence interval.

Here’s an example of a trading rule:?

• Buy value (or growth) when the asset class is in its bottom quartile of relative valuation (cheapest quartile versus the last 10 years)
• Otherwise, invest 50% in value and 50% in growth, the buy-and-hold benchmark.??

Variations involve looking at different lookback windows (one, three, five, and 10 years) and thresholds to trigger a hypothetical trade (whether based on dividing up the investment universe into median, thirds, quartiles, or deciles).?

This exercise’s information ratio (alpha divided by tracking error) has been close to zero over the last 20 years. No amount of data mining would change that conclusion. We also replicated this experiment with E/P and CF/P as the valuation metrics, and the results were the same.?

Asset allocators could improve on these results by using methods similar to those employed by skilled stock pickers: adjusting the signal for profitability and focusing more on fundamental, macro, and sentiment catalysts.?

A committee member mentioned that, when using relative valuation as a signal, “it’s important to differentiate between rational and irrational markets. There are times — like during the tech bubble or even in 2021 — when the misallocation of capital becomes obvious. In these markets, it seems like the more expensive the stock, the better it performs. These situations don’t tend to end well. Value had its best period of outperformance following the tech bubble and in 2022.”?

Also, one of the simplest ways to cure the relative valuation malaise has been to add a momentum filter (see gray line in Figure 5 below). When an asset class is cheap and shows positive short-term momentum, the valuation signal tends to work better.?

In our process, the Asset Allocation Committee (AAC) has often overweighted growth stocks despite their apparent unattractive relative valuation to value stocks. Usually, it was based on bottom-up research from our stock analysts. Asset allocators typically don’t use bottom-up research as an input. It differentiates our process. Several Asset Allocation Committee members manage equity portfolios. We’ve gotten comfortable overweighting growth stocks in the past based on their view that fundamentals were stronger than what the market was pricing in, especially regarding the cash-flow momentum created by disruptive technologies.?

That’s not the case now. Markets appear to have priced-in high expectations for growth stocks, making a strong case for value stocks. However, if you retain anything from this article, it should be that the valuation spread alone does not guarantee that values come back. ?

“So what will be the catalyst?” Charles Shriver would ask.??

We see a few:??

• Analysts expect earnings to accelerate for value companies.?
• Sticky inflation could lead to higher-than-expected interest rates, placing a higher implied discount on growth stocks’ future earnings.?
• Value companies might benefit from investments in green energy and measures to support domestic production in the face of Chinese competition and geopolitical risks.?

Yet, given the general trend toward lower growth and interest rates, this is not a pound-the-table moment for value. Our committee will maintain our moderate overweight position and look for better entry points to add more to value stocks.??

To sum it all up: Relative valuation investing is not dead. This discipline has historically paid off for those willing to endure the discomfort of being contrarian.??

But to avoid a 20-year performance drought, skilled investors have had to step away from relative valuation dogma, turning instead to a mix of judgment, accounting adjustments, fundamental research, an understanding of technology trends, and a view on macro and sentiment catalysts.??

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******?

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I sincerely thank Cesare Buiatti for his invaluable empirical work. I also appreciate the help of Charles Shriver, Rob Panariello, Dave Eiswert, and Peter Stournaras in conducting this analysis.?

REFERENCES?

1 See back test results in Page, Sébastien (2020), “Beyond Diversification: What Every Investor Needs to Know About Asset Allocation”, McGraw-Hill; p 45-60. Asness et al. (2013), “Value and Momentum Everywhere,” Journal of Finance, Vol. 68, Issue 3; Bhansali et al. (2015), “Carry and Trend in Lots of Places,” Journal of Portfolio Management, 41 (4). Summer 2015?

2 Baruch Lev and Anup Srivastava (2022), "Explaining the Recent Failure of Value Investing", Critical Finance Review: Vol. 11: No. 2, pp 333-360.?

3 Source is Ken French’s data library. -1.4% is the arithmetic average of annual (calendar) “HML” (High Minus Low B/M) factor returns between 2004 and 2023.?

? Vinod Chandrashekaran (2021), “Value Factors – The Hill Quants May Die On?”??

? See: Asness et al. (2013), “Value and Momentum Everywhere,” Journal of Finance, Vol. 68, Issue 3, and Bhansali et al. (2015), “Carry and Trend in Lots of Places,” Journal of Portfolio Management, 41 (4). Summer 2015.?

Book to price (B/P) is used to evaluate a company’s book value relative to its current market value, comparing its stock. A high B/P ratio signals a stock may be undervalued, where a lower than one means the stock price is trading at a premium.?

Cash flow to price (CF/P) measures the operating cash flow per share of a stock relative to its value.?

Earnings yield (E/P) is the earnings per share (E) divided by the market price (P) of each share.?

Information ratio is a?measurement of portfolio returns above the returns of a benchmark to the volatility of those returns.?

Relative Valuation is the concept of comparing the price of an asset to the market value of similar assets. ?

For additional definitions of terms please see https://www.troweprice.com/en/us/glossary ?

Please see Vendor Indices Disclaimers for more information about the sourcing information: https://www.troweprice.com/en/us/market-data-disclosures ?

IMPORTANT INFORMATION?

The views contained herein are those of the author as of May 2024 and are subject to change without notice; these views may differ from those of other T. Rowe Price companies and/or associates.?

This material is for general purposes only. It does not constitute or undertake to give advice of any nature nor is it intended to serve as the primary basis for an investment decision. The material does not constitute a distribution, an offer, an invitation, a personal or general recommendation, or a solicitation to sell or buy any securities in any jurisdiction or to conduct any particular investment activity. Prospective investors are recommended to seek independent legal, financial, and tax advice before making any investment decision.?

Past performance is not a reliable indicator of future performance. All investments are subject to market risk, including the possible loss of principal. Stock prices can fall because of weakness in the broad market, a particular industry, or specific holdings. Bonds may decline in response to rising interest rates, a credit rating downgrade or failure of the issue to make timely payments of interest or principal. The value approach to investing carries the risk that the market will not recognize a security’s intrinsic value for a long time or that a stock judged to be undervalued may actually be appropriately priced. Growth investments are subject to the volatility inherent in common stock investing, and share prices may fluctuate more than income-oriented stocks. Investing in technology stocks entails specific risks, including the potential for wide variations in performance and usually wide price swings, up and down. Technology companies can be affected by, among other things, intense competition, government regulation, earnings disappointments, dependency on patent protection and rapid obsolescence of products and services due to technological innovations or changing consumer preferences. Diversification cannot assure a profit or protect against loss in a declining market.??

Information and opinions presented have been obtained or derived from sources believed to be reliable and current; however, we cannot guarantee the sources’ accuracy or completeness. There is no guarantee that any forecasts made will come to pass. The charts and tables are shown for illustrative purposes only. Certain assumptions have been made for modeling purposes, and this material is not intended to predict future events.?

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