Cheap stocks outperform expensive stocks. It is a well-documented investment anomaly. Investors are compensated for owning stocks by not only earning the return of the market, but an additional “value premium.” It exists over the long-term, but does not work every quarter or every year. Companies possessing value characteristics such as a low Price to Earnings Ratio are put into the value “style” (as opposed to the growth style).
Why own small companies classified as ‘value’ versus small growth companies? Over the last 36 years in the United States, the small value index outperformed by nearly three times. Large value stocks outperformed large growth stocks by 42% over this period.
Is this just a U.S. abnormality? Looking at international markets, the answer is definitely ‘No.’ In fact, the exact same ranking order for size and style as in the U.S. was evident for as long as we have data, which is back to 1994. Both went from Small Value, to Large Value, to Large Growth, to Small Growth.
Over the same time frame, companies in the emerging markets based on size (large, small) and style (value, growth) ranked in the same order as the international developed market peers. It is clear the value premium exists in addition to a small cap premium (which we will leave for another time).
Yet, this does not hold for the last five years across regions. In fact, the worst performing style (small growth) over the multi-decade periods we looked at performed the best in each region.
Note that growth outperformed value across both large cap and small caps in the U.S., Internationally, and Emerging Markets (EM).
One reason for the difference in style performance the last five years is sector dispersion. With biotechnology and pharmaceutical companies reaping the benefit of years of research and development costs on building a pipeline of drugs, the healthcare sector shot through the roof. The American consumer continues to shop and go out to eat, boosting share prices for the discretionary sector. Technology is on fire from all the fundraising in Silicon Valley (a sign of excess perhaps with an HBO show called “Silicon Valley”) and growth from Facebook, Google, Apple, et al.
Looking under the hood of the small cap style indices shows a big difference in weights in these three top performing sectors over the past five years.
In total, the U.S. small growth index has nearly 3 times as much sector exposure to healthcare, consumer discretionary, and technology as the U.S. small value index. For today, the growth ‘style’ is in and value is out, with sector exposure being the main driver of the difference.
The “momentum premium” typically rules in the short-term, with assets outperforming on a relative basis persisting with outperformance anywhere from 2-12 months into the future. We highly doubt that cheap stocks will underperform expensive stocks in the long-term, however, cyclical periods of growth outperformance occurred in the past and likely will again.
This material is based on public information as of the specified date, and may be stale thereafter. Aurum Wealth Management Group and/or Aurum Advisory Services has no obligation to provide updated information on the securities or information mentioned herein. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates.