U.S. Equities: Assessing the Opportunity in Value amid Disruption | Lord Abbett
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Market View

Value stocks have had a rough road, but we believe there is reason for optimism for those with agility and durability.

Read time: 4 minutes

Here, Market View presents a second excerpt from a forthcoming whitepaper, “Five Equity Myths that May Be Derailing Investors.” (Read the first excerpt here.)

Myth: “Value investing is dead”

After a decade and a half of underperformance relative to growth, key value indexes and most active managers have lagged far behind the broad equity market, and even further behind growth indexes.1 As a result, we have seen a rise in assertions that “value is dead,” either as a factor or as an investment discipline.

This is not the first time we’ve heard this proclamation or some variant of it. Most notably, it was a common refrain in the late 1990s, which ultimately gave way to a seven-year period (March 2000–May 2007) where value subsequently outperformed growth by a cumulative 130 percentage points.[1]

To be sure, value as a style has underperformed since 2007, as shown in Figure 1.

 

Figure 1. Tracking Value and Growth Since 2007

Performance of Russell 1000® Value and Russell 1000 Growth® indexes for the years 2007-2020 (December 29, 2006=100)

Source: Bloomberg. Data compiled February 26, 2021.
Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

We believe there are two key reasons for this underperformance:

  1. Value indexes are not identifying value stocks by their original and aspirational definition, but rather relying on a formulaic approach to cheapness as represented by low price-to-book value (P/B) ratios, a factor that many practitioners and academics increasingly argue is now impaired and unlikely to reprise its renowned performance from the 1960s-1980s.
  2. The accelerating pace of innovation has disrupted numerous less-agile industries and business models, widening the disparity between technology-enabled “growth” businesses and non-innovators.

We argue that investors may need to move away from rigidly defining value based solely on the Value Factor—which identifies the cheapest stocks as defined by P/B– and instead focus on metrics that reveal operating strength and/or improvement, operational agility, and market durability. Price-to-book cheapness did perform well in the second half of the 20th century, but we believe the factor has more recently lacked reliability, which is further discussed in this recent paper.

While we believe success of the formulaic price-to-book approach has diminished, we do not believe value investing is dead. Rather, we believe that investors should return to the essence of Graham-Dodd Value investing,2 which is founded on the basis of seeking a “margin of safety” in stocks by identifying companies trading at a discount to their future intrinsic value—a process that requires an assessment of anticipated operating performance rather than simply the book value of equity on their balance sheets.  Based on an approach that identifies companies trading at a significant discount to their future cash flows and earnings, we believe there are many very attractive opportunities today in the fallout from the economic damage wrought by  COVID-19, which mercilessly took down a number of otherwise durable businesses. And in this sense, value is very much alive and well, but investors need to be cognizant of the pitfalls of “value traps” that can lure them in with ostensible cheapness based on current price-to-book valuations.

One key reason for the declining predictive power of the value factor is the receding relevance of book value equity of companies, as the vast majority of company assets today that drive business operations and earnings potential are now intangibles, which are not generally included in book value. Thus, companies do not need to have a high degree of asset intensity in physical capital to prosper in the modern era.

Figure 2 highlights the dramatic transformation of asset intensity among S&P 500® Index companies over the last 45 years.  In 1975, we can see that book value was a fair way to assess a company’s worth, as tangible assets made up 83% of total assets of index members.  However, in recent years, that level has fallen below 20%. We believe this shift is critical as competitive battles are increasingly being won or lost based on the level of a company’s intellectual capital and the agility of their business models, yet these are intangible assets that are not incorporated in the stated book value of equity.

 

Figure 2. Asset Intensity Has Shifted Dramatically Toward Intangibles Over the Decades

Source: BofA Research, The RIC Report, September 8, 2020, “The Secret Life of Value”. Data are most recent available. Tangible assets are physical; they include cash, inventory, vehicles, equipment, buildings and investments. Intangible assets do not exist in physical form and include things like accounts receivable, pre-paid expenses, and patents and goodwill.

 

As a result of this shift to a more asset-light economy, seeking out cheap price-to-book companies does not necessarily result in underpriced opportunities. In fact, some of these companies may instead be value traps as they tend to be less agile and/or in declining industries, and as a result, often face the risk of disruption as the pace of innovation quickens.

A More Intuitive Way to Assess Value
Given what we view as the shortcomings of a formulaic approach and price-to-book cheapness in isolation, we believe that investors should focus instead on the original heritage of value investing. This involves assessing the operating potential of the underlying company and identifying potential mispricing by determining whether it displays characteristics that signal long-term durability.

One metric that we have found be effective in this regard is normalized free cash flow yield, which we believe can help better identify self-reliant, resilient businesses. The concept of durability in cash flows as well as flexibility in thinking about valuations (i.e., de-emphasizing P/B in favor of more relevant metrics) is one we consider critical in identifying investment candidates in an environment marked by widespread innovation-related disruption. Since the pace of disruption has accelerated in many areas of the economy during the pandemic, we believe that many companies that were already vulnerable to displacement risk are even more so today, while other, more resilient companies have been unfairly sold off despite strong prospects for recovery as the economy re-opens.

We think an emphasis on free cash flow yield can help identify attractively valued stocks in the current environment and for the long run. In Figure 3, we see that free cash flow yield has historically been a far superior forecasting tool than P/B for a long time, and particularly in the last 20 years.

 

Figure 3. For Value Investors, Free Cash Flow Yield Historically Has Been a Better Predictor of Performance

Annualized relative returns (%) to the cheapest quintile of price-to-book and free cash flow-to-enterprise value, 1952 through mid-January 2021

Source: Empirical Research Partners Analysis. Monthly data compounded. Equally-weighted returns for free cash flow-to-enterprise value. free cash flow is a measure of profitability that excludes the non-cash expenses of the income statement and includes spending on equipment and assets as well as changes in working capital (i.e., current assets minus current liabilities) from the balance sheet. Enterprise value includes in its calculation the market capitalization of a company but also short-term and long-term debt as well as any cash on the company's balance sheet.

 

But even armed with this data, we still do not advocate for a formulaic approach to any one metric. Exclusively focusing on companies that generate high free cash flow is not sufficient either for identifying long-term winners, in our view. Rather, taking a more holistic approach, and not relying on narrow individual metrics whose relevance may fade over time, investors can identify and avoid companies that are vulnerable to displacement. To reiterate: Value is not dead. It just needs a more active approach.

 

 

 

 

1In the text of this article, comparisons of growth stocks, value stocks, and the broad U.S. equity market are as measured by the performance of the Russell 3000® Growth, Russell 3000® Value, and S&P 500® Indexes, respectively.

2Value investing was popularized by Columbia Business School faculty members Benjamin Graham and David Dodd, co-authors of the text, Security Analysis (1934). Graham held that the true value of a stock could be determined through research. He worked with Dodd to develop value investing, a methodology to identify and buy securities priced well below their true value.

 

A Note about Risk: The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. While growth stocks are subject to the daily ups and downs of the stock market, their long-term potential as well as their volatility can be substantial. Value investing involves the risk that the market may not recognize that securities are undervalued, and they may not appreciate as anticipated. Smaller companies tend to be more volatile and less liquid than larger companies. Small cap companies may also have more limited product lines, markets, or financial resources and typically experience a higher risk of failure than large cap companies. The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall.

No investing strategy can overcome all market volatility or guarantee future results. 

Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

This Market View may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize, or that actual returns or results will not be materially different from those described here.

Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future.

Glossary and Index Definitions

 

Earnings per share (EPS) is a company’s earnings divided by the number of shares outstanding. EPS can also be computed for an index such as the S&P 500.

Factor investing is an investment approach that involves targeting specific drivers of return across asset classes. 

Formulaic value refers to investment strategies that use ratios of common fundamental metrics (e.g., book value, earnings) to market price to determine the perceived attractiveness of an equity investment.

 

Growth/Value Investing: Growth stocks may be characterized as equities of companies that have demonstrated better-than-average gains in earnings in recent years and that are expected to continue delivering high levels of profit growth. Growth equities typically carry higher price-to-earnings multiples than the broader market, high earnings growth records, and greater volatility than broader market. Value stocks may be characterized as equities of companies that have fallen out of favor with investors but still have good fundamentals, or new companies that have yet to be recognized by investors. Value stocks typically feature lower price-to-earnings multiples than the broader market, and, often industry peers; and somewhat lower volatility than the overall equity market.

Intrinsic valuation looks only at the inherent value of a company’s stock. Financial analysts build models to estimate what they consider to be the intrinsic value of a company's stock outside of what its perceived market price may be on any given day, based on the present value of expected future cash flows.

The Price-to-Book ratio compares a company's market value to its book value. The market value of a company is its share price multiplied by the number of outstanding shares. The book value is the net assets of a company.

Price-to-Earnings Ratio: Stock analysts calculate a price-to-earnings ratio by dividing a stock's current price by its earnings per share on a trailing 12-month basis. A forward price-to-earnings ratio is calculated by dividing a stock's current price by estimated future earnings per share.

The Russell 1000® Index measures the performance of the 1,000 largest companies in the Russell 3000 Index, which represents approximately 92% of the total market capitalization of the Russell 3000 Index.

The Russell 1000® Growth Index measures the performance of those Russell 1000 companies with higher price-to-book ratios and higher forecasted growth values.

The Russell 1000® Value Index measures the performance of those Russell 1000 companies with lower price-to-book ratios and lower forecasted growth values.

The Russell 3000® Index measures the performance of the largest 3000 U.S. companies representing approximately 98% of the investable U.S. equity market.

The Russell 3000® Growth Index measures the performance of those Russell 3000 Index companies with higher price-to-book ratios and higher forecasted growth values.

The Russell 3000® Value Index measures the performance of those Russell 3000 Index companies with lower price-to-book ratios and lower forecasted growth values.

The S&P 500® Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries.

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

The information provided herein is not directed at any investor or category of investors and is provided solely as general information about our products and services and to otherwise provide general investment education.  No information contained herein should be regarded as a suggestion to engage in or refrain from any investment-related course of action as Lord, Abbett & Co LLC (and its affiliates, “Lord Abbett”) is not undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity with respect to the materials presented herein.   If you are an individual retirement investor, contact your financial advisor or other non-Lord Abbett fiduciary about whether any given investment idea, strategy, product, or service described herein may be appropriate for your circumstances.

The opinions in this Market View are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

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