Top

Dimensional Perspectives

These have been challenging times for value stocks. Over the 10-year period ending March 31, 2020, the Fama/French US Value Research Index returned an annualized 5.06%, well behind the 13.04% achieved by the Fama/French US Growth Research Index. This performance divergence has resulted in a substantial widening of the price-to-book spread between value and growth stocks in the US, as shown in Exhibit 1.


Exhibit 1: Spread's Up
Aggregate price-to-book ratios for value stocks vs. growth stocks, US market, July 1926–March 2020

Source: CRSP and Compustat. Stocks are sorted on book-to-market ratio each June, where book-to-market for year t is computed using the book equity for the last fiscal year-end in t-1, divided by market equity for December of t-1. Value and growth are stocks with book-to-market ratios above and below the 70th and 30th percentiles for NYSE stocks, respectively. Aggregate price-to-book value computed as the inverse of the weighted average book-to-market ratio where market equity is for the current month.

 

Extending this analysis to different markets and asset classes reveals further evidence of widening valuation spreads between value and growth. As we see in Exhibit 2, spreads among large cap stocks in the US, non-US developed, and emerging markets have all generally expanded over the past decade. This was also true for small cap stocks in the US and non-US developed markets, with only emerging markets small caps bucking the spread-widening trend.


Exhibit 2: Widespread Growth
Aggregate price-to-book ratios across markets

Source: CRSP, Compustat, and Bloomberg. Aggregate price-to-book value computed as the inverse of the weighted average book-to-current month to date market value.

Size definitions: Stocks sorted using market equity as of each June. In the US, small caps, and large caps are defined relative to the median market capitalization of stocks listed on the NYSE. In non-US developed markets, large cap and small cap represent the top 90% and bottom 10%, respectively, of aggregate market capitalization. In emerging markets, large cap and small cap represent the top 90% and bottom 10%, respectively, of aggregate market capitalization within each country. 

Value definitions: Stocks are sorted on book-to-market ratio each June, where book-to-market for year t is computed using the book equity for the last fiscal-year end in t-1, divided by market equity for December of t-1. In the US, value and growth are stocks with book-to-market ratios above and below the 70th and 30th percentiles for NYSE stocks, respectively. In non-US developed markets, value and growth are stocks with book-to-market ratios above and below the 70th and 30th percentiles for large cap stocks in each region (Japan, Asia Pacific ex Japan, Canada, and Europe). In emerging markets, value and growth are stocks with book-to-market ratios above and below the 70th and 30th percentiles for large cap stocks in each country.

 


What do we make of the valuation ratio data? A stock’s price represents the value of a company’s expected future cash flows discounted back to the present. So low valuations can result from low expectations of future cash flows, high discount rates, or a mix of the two. It’s not possible to cleanly isolate cash flow and discount rate effects from the data. But to the extent that low valuations reflect high discount rates, expected returns will be higher going forward. 

To the extent that widening spreads between value and growth are attributable to increases in the discount rates for value relative to growth, the implication would be a higher expected value premium. However, research from Dai (2016)1 suggests investors should be cautious using valuation spreads as inputs for asset allocation decisions. While regression analysis provides some evidence of a link between valuation spreads and subsequent value premiums, hypothetical timing strategies that switch between value stocks and growth stocks based on the spread in their valuations fail to consistently outperform a simple buy-and-hold value strategy.

What’s the takeaway for investors? Even if the spreads in valuations between value and growth vary through time, the important part is that there is a spread. Investors demand different expected returns across stocks, and that shows up in part through different valuations. It’s reasonable to expect that securities with lower prices relative to fundamentals should have higher expected returns. While value premiums may not show up every day, year, or decade, we believe maintaining consistent exposure to value stocks is the most robust approach for capturing the value premium, regardless of current valuations.


Glossary

Price-to-book ratioThe ratio of a firm’s market value to its book value, where market value is computed as price multiplied by shares outstanding and book value is the value of stockholder equity as reported on a company’s balance sheet.

Value stockA stock trading at a low price relative to a measure such as book value or earnings.

Value premiumThe return difference between value stocks and growth stocks.

Growth stockA stock trading at a high price relative to a measure such as book value or earnings.

Market capitalizationThe total market value of a company’s outstanding shares, computed as price times shares outstanding.

Discount rateThe rate of return that determines the present value of a company’s expected future cash flows.

Regression analysisA statistical technique for estimating the strength of the relation between one variable and one or more other variables.


Learn More

Under the Macroscope: When Stocks and the Economy Diverge

Can Small Cap Stocks Weather the Storm?

Long-Term Investors, Don’t Let a Recession Faze You



Previous Post
Next Post

1Wei Dai, “Premium Timing with Valuation Ratios” (white paper, Dimensional Fund Advisors, 2016).

 

 


 

The information in this document is provided in good faith without any warranty and is intended for the recipient’s background information only. It does not constitute investment advice, recommendation, or an offer of any services or products for sale and is not intended to provide a sufficient basis on which to make an investment decision. It is the responsibility of any persons wishing to make a purchase to inform themselves of and observe all applicable laws and regulations. Unauthorized copying, reproducing, duplicating, or transmitting of this document are strictly prohibited. Dimensional accepts no responsibility for loss arising from the use of the information contained herein.

“Dimensional” refers to the Dimensional separate but affiliated entities generally, rather than to one particular entity. These entities are Dimensional Fund Advisors LP, Dimensional Fund Advisors Ltd., Dimensional Ireland Limited, DFA Australia Limited, Dimensional Fund Advisors Canada ULC, Dimensional Fund Advisors Pte. Ltd., Dimensional Japan Ltd., and Dimensional Hong Kong Limited. Dimensional Hong Kong Limited is licensed by the Securities and Futures Commission to conduct Type 1 (dealing in securities) regulated activities only and does not provide asset management services.

Eugene Fama and Ken French are members of the Board of Directors of the general partner of, and provide consulting services to, Dimensional Fund Advisors LP.

UNITED STATES: Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission.

AUSTRALIA: This material is issued by DFA Australia Limited (AFS License No. 238093, ABN 46 065 937 671). This publication is provided for information only. No account has been taken of the objectives, financial situation or needs of any particular person. Accordingly, to the extent this material constitutes general financial product advice, investors should, before acting on the advice, consider the appropriateness of the advice, having regard to the investor’s objectives, financial situation and needs. Any opinions expressed in this material reflect our judgment at the date of publication and are subject to change.

Neither Dimensional Ireland Limited (DIL) nor Dimensional Fund Advisors Ltd. (DFAL), as applicable (each an “Issuing Entity,” as the context requires), give financial advice. You are responsible for deciding whether an investment is suitable for your personal circumstances, and we recommend that a financial adviser helps you with that decision.

WHERE ISSUED BY DIMENSIONAL IRELAND LIMITED
Issued by Dimensional Ireland Limited (DIL), with registered office 10 Earlsfort Terrace, Dublin 2, D02 T380, Ireland. DIL is regulated by the Central Bank of Ireland (Registration No. C185067). Information and opinions presented in this material have been obtained or derived from sources believed by DIL to be reliable, and DIL has reasonable grounds to believe that all factual information herein is true as at the date of this document.

DIL issues information and materials in English and may also issue information and materials in certain other languages. The recipient’s continued acceptance of information and materials from DIL will constitute the recipient’s consent to be provided with such information and materials, where relevant, in more than one language.

WHERE ISSUED BY DIMENSIONAL FUND ADVISORS LTD.
Issued by Dimensional Fund Advisors Ltd. (DFAL), 20 Triton Street, Regent’s Place, London, NW1 3BF. DFAL is authorised and regulated by the Financial Conduct Authority (FCA). Information and opinions presented in this material have been obtained or derived from sources believed by DFAL to be reliable, and DFAL has reasonable grounds to believe that all factual information herein is true as at the date of this document.

DFAL issues information and materials in English and may also issue information and materials in certain other languages. The recipient’s continued acceptance of information and materials from DFAL will constitute the recipient’s consent to be provided with such information and materials, where relevant, in more than one language.

RISKS
Investments involve risks. The investment return and principal value of an investment may fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original value. Past performance is not a guarantee of future results. There is no guarantee strategies will be successful.