A Peculiar 2Q16
You don’t see many asset managers proclaiming “We buy stagnating or low-growth businesses trading at average prices” — yet that’s the profile of the stocks that quietly started to lead the market this time last year, persisting well into the 2nd Quarter. Let’s explore the “peculiar” characteristics of this rally…
A spike in price-to-book’s performance certainly plays a role in this anomaly (for more background on the growing blind spot created by price-to-book, see our post When a “Value” Company is not a Value). But in this article I’ll focus on why the gap of value versus growth indices is more “a surge in stocks with terrible sales and earnings growth” and less a “triumph of traditional cheap over expensive”.
Low-Growth Companies Drove Value’s Outperformance
By the end of 2Q16, the Russell 1000® Value had beaten the Russell 1000® Growth by a margin of almost 5%.1 Other than price-to-book, most measures of “value” did poorly in that same period. So why the large gap between Russell’s value and growth indexes?
The answer lies in how Russell defines value versus growth. They use a ranking formula which is 50% value (price-to-book) and 50% growth (EPS growth and 5-year sales growth) to decide where each stock falls on Russell’s value/growth spectrum. Anything “cheap and/or with horrible growth” is considered value and “anything with great growth and/or extremely expensive” is considered growth. This methodology creates a dynamic where a portion of the Russell Value index actually includes “slightly expensive stocks with very bad trailing sales growth and expected EPS growth”. Likewise, a portion of the- growth index includes stocks with “below average or negative growth” — their extremely expensive valuations qualified them as growth.
In rare occasions, these overlooked groups of stocks can drive performance of the style indices, which is exactly what we saw in the first half of 2016 with the Russell 1000 Value Index. The chart below shows the excess return of value versus growth for each of the factors used in Russell’s methodology. Whereas we generally use decile portfolios in our own research2 to highlight different value factors (see our Factor Alpha Newsletter), we now tailor the analysis to sync more closely with Russell’s method, which carves the market into thirds. We start with the constituents of the Russell 1000 and calculate the return difference between the top third and bottom third by each factor. For example, the return of +1.3% for price-to-book is the result of:
- Ranking the cheapest third of stocks by price-to-book in the Russell 1000 to build our portfolio,
- Calculating the return (weighted by market capitalization) of that portfolio for the year,
- Doing the same for the most expensive third, and
- Subtracting one from the other.
You can see that, although the cheapest third of stocks outperformed the most expensive third by price-to-book within the Russell 1000, the difference is relatively small. The real story here is the outperformance of low growth over high growth. Companies with the lowest sales and earnings growth outperformed those with the highest growth by 8% to 9% by the end of 2Q16.
Any active manager seeking to avoid companies with dismal growth risks missing out on the companies that are really driving returns in the benchmark.
Value vs. Growth — Cumulative Excess Return
(Russell 1000 constituents, 1/1/16 through 6/30/16)
“Expensive, with Negative Growth” = 2Q16’s Top 10 Contributors for R1000V
This becomes even more apparent when you look at the profile of the top performers in the Russell 1000 Value Index. The 10 stocks in the table below (2Q16’s top contributors to the benchmark return) comprised only 20% of the benchmark, yet contributed more than half of the return! 3
For each stock, we show the percentile rank of price-to-book, EPS growth, and 5-year sales growth at the beginning of 2016 versus the Russell 1000.4 Only 3 of the 10 stocks made it into the cheapest third of U.S. companies by price-to-book, and the average is just under the median. Further, 9 of the 10 stocks had negative earnings growth (i.e., shrinking earnings) to start 2016 and more than half had shrinking sales. The average of these 10 stocks had earnings that shrank 27.5% over the last year, a reduction in total sales of 8.5% over the last 5 years, and they were only slightly less expensive than the market median. Stocks with similar characteristics — negative earnings growth companies near the median by price-to-book — underperform the market 65% of the time.5
Top 10 Contributors to the Russell 1000 Value (1/1/16 through 6/30/16)
Using Russell style benchmarks to build a market narrative makes sense: they are well regarded and widely-followed. But the returns of value versus growth can be misleading. Cheap didn’t beat expensive in 2Q16, on average, but low growth crushed strong growth. Over the longer term, a strong strategy is to be “long cheap stocks” not “long low-growth businesses”. But here’s the rub: being long cheap stocks failed — peculiarly — in the first half of 2016.
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- From 1/1/16 to 6/30/16 the Russell 1000 Value returned 6.3% while the Russell 1000 Growth was up 1.35%.
- For example, OSAM Value’s top decile is “the cheapest 10% of stocks” within the universe.
- R1000V’s Top 10 returned 3.5%, while the overall R1000V return was 6.3%.
- 1 is the cheapest/highest-growth percentile and 100 the most expensive/lowest-growth.
- Measured using a portfolio of every stock that ranks in the middle 1/3 of the Large Stocks Universe by price-to-book and also has negative earnings growth. The annualized return of this portfolio was lower than the equal-weighted large stocks portfolio in 65% of all rolling 12-month periods from 1964 through 2015.