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White Paper July 2005 The Trouble with Value or Please Stop Listening to Your Value Managers
Ben Inker
We value investors tend to be a fairly smug lot, particularly these days. Firmly convinced of our innate superiority over growth managers with their endless chasing of the latest fad we talk confidently about investing for the long run, behavioral inefficiencies, and the recycling of opportunities. The historical data is handily in our favor. The Russell 1000 Value index has outperformed the Russell 1000 Growth index by 2.2% per year since their inception in 1979. Splitting the S&P 500 into cheap and expensive halves on price/book shows an advantage for value over growth of 2.1% per year since 1960. The data for other markets is, if anything, stronger, with the cheapest 50% of stocks on price/book beating the most expensive by 4.9% per year in the EAFE markets since 1975. With data like that in your favor, its hard not to want to shout it from the rooftops. The trouble is, one of the worst things that can happen to value managers is to have investors actually listen to them, and by the looks of things, investors are all ears at the moment. The story behind value investing is beguilingly simple. Investors systematically overpay for growth, which turns out to be much more difficult to forecast than they think, and they underestimate the power of reversion to the mean to bring back some of even the more hopeless looking companies to moderate respectability (not to mention profitability). This has meant that simply buying companies with low price/book or price/earnings ratios has given substantially better returns than the overall market, with the added benefit of lower absolute volatility. What could be better or more straightforward? The trouble is, as comforting as it is to believe that investors have it all wrong, they in fact have it mostly right. They dont have it completely right, for which active managers should be grateful, but they do get it right often enough to keep a smart value manager up at night, particularly today. So what does it mean to say that investors get things mostly right? The basic reason why companies should trade at different levels of valuation is due to differential forecasts of growth and/or profitability. In an efficient market, low P/E stocks are trading at that low P/E because investors estimate that their earnings growth will be sub-par, whereas high P/E companies have better than average prospective earnings. This can be seen in Exhibit 1, which shows prospective one year earnings growth for companies decilized by P/E. The lowest P/E companies have earnings growth 23% lower than the average, and the highest P/E companies have earnings growth 26% higher. Obviously, the market knows quite a lot about earnings growth it turns out that
Exhibit 1 Decile of P/E to Predict Earnings Growth
30%

26%
Next Year's Relative Earnings Growth 20%

11%
10%

8% 1% 3%

0%

-2%
-10%

-6% -10%

-4%

-20%

-23%
-30% Low est 2 3 4 5 6 7 8 9 Highest
Source: GMO

Decile of P/E

Cumulative Performance of Value versus Growth

P/E is as good a predictor of earnings growth as you will find. But you wouldnt want to blindly invest in the high P/E stocks just because they are going to grow the fastest. Since the market knows that the growth is going to occur, it doesnt actually do you any good, as can be seen in Exhibit 2, which shows the next years return for the same deciles of P/E. Despite the fact that the lowest P/E stocks are going to have their earnings shrink over the next year, they have still historically been the ones to own. The market is not entirely wrong in its estimates of future growth, but it does tend to overreact a bit, which is what value managers exploit. But at the risk of sounding insane, there is more to life than returns. If we want to know how a group of stocks is going to perform in the future, it would be helpful to know not just how they did in the past, but where those returns came from. Exhibit 3 shows the historical performance of the Russell 1000 Value index versus the Russell 1000 Growth index. While the overall outperformance by value is indeed 2.2% per year, there are some features of the return pattern that are a bit worrying. As recently as 2000, value had actually underperformed growth over the whole time period. Over their 26-year history, more than 100% of
Exhibit 2 Decile of P/E to Predict Next Years Return
4%

Exhibit 3 Performance of Russell 1000 Value vs. Russell 1000 Growth

80% 70% 60% 50% 40% 30% 20% 10% 0% -10% -20% -30% Dec- 78 80 82 84 86 88 90 92 94 96 98 00 02 04
As of 4/30/05. Source: Frank Russell

the outperformance of the Russell 1000 Value index over the Russell 1000 Growth index has occurred in the last five years. Students of recent history might reply that the underperformance was only because of the enormity of the technology bubble of 1998-2000, and they would have an excellent point. But it is instructive to ask the question of why their point is such a good one. Implicit in the excusing of value for the technology bubble is the idea that the bubble set up value for its run since then. The way this setting up would have occurred is to have had the discount at which value stocks traded be particularly wide in that period. Exhibit 4 shows the relative valuation of the Russell 1000 Value index versus the Russell 1000 Growth index on price/sales. The red line on the graph is the relative price/sales of value stocks, the black line is the average, and the blue and green lines are 1 and 2 standard deviations away from average, respectively. The most striking feature of the graph is the 1998 to 2000 chasm where the price/sales of value dropped as low as 28% of the price/sales of growth. Armed with this data, we can learn not only that the technology bubble did indeed set up the value rally which followed, but also that the value effect was actually alive and well even at the nadir of value, if you looked at things the right way. From 1979 to June of 2000, the
2 The Trouble With Value, July 2005

3%
3% Next Year's Return versus Market

3%

2%

1%
1%

0%
0%

-1%

-1% -1% -1% -2% -3%

Low est 2 3 4 5 6 7 8 9 Highest
Source: GMO

-2%

-2%

-3% Decile of P/E

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Exhibit 4 Relative Price/Sales of Russell 1000 Value and Growth

0.9

Exhibit 5 Relative Price/Earnings of Russell 1000 Value and Growth

0.9

0.8

0.8

Relative Price/Earnings
As of 4/30/05. Source: GMO

0.7 Relative Price/Sales

0.7

0.6

0.6

0.5

0.5

0.4

0.3

0.4

0.2 Dec- 78 80 82 84 86 88 90 92 94 96 98 00 02 04

0.3 Dec- 78 80 82 84 86 88 90 92 94 96 98 00 02 04
As of 4/30/05. Source: GMO

Russell 1000 Value index underperformed the Russell 1000 Growth index by a cumulative 25%, but its relative price/sales dropped from 0.46 to 0.28. Adjusted for that valuation shift, value actually outperformed growth by 1% over the period! That is to say, had value stocks started and ended the period at 0.46 times the price/sales of growth stocks, their relative performance wouldnt have been -25% (-1%/year), but +24% (1%/year). The period since then in which value stocks have outperformed by 138% has seen valuations move up from 0.28 to 0.74, which is a 162% increase. This means that 100% of the outperformance has been due to valuation shift. The outperformance of value over the entire period net of valuation shift is now a somewhat disheartening 0.44%/year, which is not particularly impressive. This analysis assumes that price/sales is the right way to value stocks, which is certainly open to debate. But the general picture doesnt change much if we use a different valuation metric. On price/earnings, for example, the valuation chart looks like Exhibit 5. This metric makes value look a bit better. Over the history of the Russell indices, the outperformance of value, adjusted for P/E shift, has been 1.8%/year. A big reason for this better result is that value stocks are currently closer to their long-term average P/E relationship with growth stocks than they are to their long-term price/sales
The Trouble With Value, July 2005 3

relationship. They are 1.0 standard deviation expensive on price/earnings, and 1.7 standard deviations expensive on price/sales. But in either case, we are left with a worrying development. While value has indeed outperformed growth over this period adjusted for valuation shifts, that outperformance occurred at an average valuation noticeably lower than today. Value stocks trade at 0.74 times the price/sales and 0.75 times the price/earnings of growth stocks, versus averages of 0.52 and 0.65, respectively. The question we therefore have to ask ourselves is whether it makes sense to assume that value stocks will outperform starting from these levels. One way to check that is to look at a decile run of the performance of value stocks on price/sales and price/earnings, which we can see in Exhibit 6. The valuation of value stocks turns out to say quite a bit about how well you should expect them to do over the next three years. If you bought value stocks in the cheapest 10% of their historical range, they outperformed growth by 10%/year and 14%/year for the next three years on price/sales and price/earnings, respectively. And if you bought them in the most expensive 10% of their range, they actually underperformed by 6%/year for three years if the decile run was on prices/sales, and outperformed by only 0.1%/year if it was on price/earnings.

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value effect, and the pricing of value stocks will permanently stay in a range in which we should not 15% expect them to outperform. 14% The second is that the Price/Sales currently narrow spread is a 10% Price/Earnings 10% temporary phenomenon, 8% driven by reaction to the 7% 7% technology/TMT bubbles 5% 5% 4% 5% and the natural movement of 2% 2% 2% 1% money towards managers 1% 0% 0% with strong recent 0% performance. Our guess is -1% -1% that the latter is more likely. -2% -2% -2% -2% The very existence and -5% magnitude of the recent -6% bubbles in growth stocks -10% strongly suggests that Low est 2 3 4 5 6 7 8 9 Highest Average investors are not growing any more rational with time. Decile of Valuation Source: GMO It would be shocking to us if they have been permanently scared straight when it comes to value and growth, And unfortunately for fans of value, on either parameter, value stocks are in their worst 10% of history. In the case given that there is no reason to believe that there has been of price/sales they are actually at their worst valuation any change in human nature, and investor memories are level ever. If history is to be our guide, therefore, we notoriously short. shouldnt expect any outperformance by value over the But even if the narrow spread and potentially tough times next few years, and it may very well underperform. for value are a temporary rather than permanent The valuation data for the EAFE markets is quite similar, Exhibit 7 as we can see in Exhibit 7.
Exhibit 6 Decile of Valuation to Predict Three-Year Outperformance of Value
Annualized Return of Value versus Growth

Relative Valuation of EAFE Value vs. EAFE Growth

Standard Deviations From Average

In this case, value stocks seem to be around 1.5 standard deviations expensive on either price/sales or price/earnings, and about as expensive as theyve ever been. The valuation adjusted performance of value has been somewhat better in the EAFE markets, however, with value winning by 2.4% and 2.1% adjusted for changes to price/earnings and price/sales, respectively. So what can we expect from value and growth in the future? The near-term data is certainly worrying. In the U.S., we are trading at valuation spreads that have historically been associated with outperformance by growth stocks. In non-U.S. markets, the valuation spreads are no better, but the historical performance of value has been so strong that there is no real history of value underperforming for any length of time (other than the TMT bubble). It strikes us that there are two possibilities for the future. The first is that the market has truly wised up about the

2 Price/Sales 1

-1 Price/Earnings -2

-3

-4 Dec- 78 80 82 84 86 88 90 92 94 96 98 00 02 04
As of 4/30/05. Source: GMO

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The Trouble With Value, July 2005

phenomenon, it still leaves the question of what investors should do with their portfolios. Is now the time to move heavily into growth? Possibly, but we are somewhat worried about taking on a strong growth bias right now, due to the high level of overall valuations. Exhibit 8 shows the valuation of the U.S. stock market on one of our favorite valuation measures, Tobins Q. While the valuation of the overall stock market is substantially lower than it was in 2000, it is as high as the peaks of previous bull markets, and this makes us worry about growth portfolios. Growth stocks have a couple of unsettling characteristics if there is a significant chance of a bear market. First, they are more volatile than value stocks, with an annual volatility since 1960 of 18.9% versus 15.7% for value (defined on price/book). Second, they are higher beta, with a beta of around 1.1 to the overall market, versus about 0.9 for value. The combination of these two factors has led growth stocks to underperform the market significantly in down quarters. If such quarters are more likely than average to occur these days, it may be tough for growth to win despite its good relative positioning. If growth stocks do not outperform as the market reverts to fair value, they are very likely to outperform in the eventual market rebound, with both relative and absolute value on their side. But this will not be of much comfort on the way down for investors who shifted to growth too soon.
Exhibit 8 Tobins Q of U.S. Corporations
3.5 3.0 Price/Replacement Cost 2.5 2.0 1.5 1.0 0.5 0.0

At GMO, we have chosen to respond to the value/growth dilemma in several ways. In asset allocation accounts, we have gone to a 50/50 weighting between value and growth, which is actually more pro-growth than we would normally be, but we have not actually moved to overweight growth portfolios versus client benchmarks. In lieu of a growth bias, we have moved to a quality bias. Higher quality companies (companies with high and stable profitability and low debt) are very cheap right now, as can be seen in Exhibit 9. While the opportunity in high quality stocks is not as extreme as it was for value stocks in 2000, high quality stocks are trading cheaper, relative to the market, than we have ever seen them. And, compared to growth stocks, high quality stocks have several substantial advantages. First, they have significantly lower volatility and beta than growth stocks. Second, they do not have the long history of underperformance that we have seen from growth stocks. High quality stocks have actually outperformed the market in the long run, despite the fact that they are, on average, growthy. They have also outperformed in bear markets, doing at least as well in down quarters as value stocks have. Within our non-asset allocation equity portfolios, we have tried to prepare as well. This is really accomplished directly through our valuation models. While traditional value models tend to pick the same group of favorite stocks no matter what the spread of value is, our models are more eclectic, moving from traditional value stocks to growthier and higher quality names as relative valuations shift. Exhibit 10 shows the overlap between the Intrinsic Value portfolio we buy in U.S. Core and the cheapest half of the market on price/book. If there was no correlation between our Intrinsic Value model and traditional value, the overlap would be 50%. On average, the overlap has been 66%, which is to say that, on average, we have felt that traditional

1926 1931 1936 1941 1946 1951 1956 1961 1966 1971 1976 1981 1986 1991 1996 2001
As of 12/31/04. Sources: Smithers & Co., Federal Reserve

The Trouble With Value, July 2005

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Exhibit 9 Relative Valuation of High Quality Stocks in U.S.

3

Exhibit 10 Overlap Between Intrinsic Value Portfolio and Cheapest 50% Price/Book
100%

2 Standard Deviations From Average Percent Overlap with Price/Book

As of 3/31/05. Source: GMO

90%

80%

70%

60%

-1

50%

-2

40% -3 Jan- 65 67 69 71 7375 77 79 81 8385 87 89 91 9395 97 99 01 03 05

30% Dec- 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04
As of 4/30/05. Source: GMO

value stocks are, in fact, cheap. But the overlap is not constant, and when the spread of value has gotten particularly wide, as in the Nifty 50 era or during the technology bubble, the overlap approached 100%. Today it has actually dipped below 50%, so the two measures are actually slightly negatively correlated. The portfolio has moved instead into higher quality stocks. Over time, our Intrinsic Value model has had an overlap with the higher quality half of the market of almost exactly 50%. But just as with traditional value, the overlap rises and falls over time, and today, as we can see in Exhibit 11, the overlap is above 70%. We believe that this flexibility on the part of our value models should allow us to weather a period of underperformance by traditional value without increasing our vulnerability to a potential bear market. But there is no question that life is easier when traditional value is trading at very cheap levels. We will certainly see such times again, but, unfortunately, we are unlikely to see them until investors stop listening to their value managers.

Exhibit 11 Overlap Between Intrinsic Value Portfolio and High 50% of Quality
90%

80% Percent Overlap with High Quality

70%

60%

50%

40%

30%

20% Dec- 70

73 76 79 82 85 88

91 94 97 00 03

As of 4/30/05. Source: GMO

The views expressed herein are those of GMO and are not intended as investment advice.
Copyright 2005 by GMO LLC. All rights reserved.

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The Trouble With Value, July 2005