Post-Crisis Returns in Europe
If history is a guide, the most profitable small value firms in Europe may be poised for a significant rebound during an economic recovery.
2020 has been full of surprises. While the widening of valuation spreads between cheap and expensive stocks is not unique to this year, it has been surprising to see that a foundational rule of investing—buy profitable companies—has not helped investors so far in 2020. Investors in both of the major style boxes, small value and large growth, have not benefitted at all this year from selecting companies with high profitability.
Below, we present evidence from Europe using Fama-French data over the year-to-date period ending September 30, 2020. European small value stocks have returned -11.1% in the YTD period versus a +6.4% return in large growth, as investors have continued to favor growth firms. While disappointing for value investors, this divergence is simply the continuation of a growth rally that began before 2020.
What is truly surprising about this year is that both small value and large growth investors who chose to hold profitable companies have not benefitted from that logical decision. In the left-hand panel of Figure 1, we overlay a profitability screen to the small value and large growth categories. We apply the measure of profitability used by Gene Fama and Ken French, which is EBITDA minus interest expense in the numerator, divided by book value. This profitability metric is akin to return on equity and it allows for comparisons of companies across industries (unlike profit margins which tend to be industry-specific).
The most profitable small value firms have returned -23.6% year-to-date (versus -11.1% in the broader small value category) and the most profitable large growth firms returned 3.1% YTD (versus 6.4% in the broader large growth category). In both cases, it appears investors would have been better off ignoring profitability at a time when the pandemic is wreaking havoc on global economies!
Figure 1: Year-to-Date 2020 Returns in Europe (September 30, 2020)
Source: Ken French data library. Value is measured in terms of Price/Book and profitability is measured in terms of [EBITDA minus interest expense] divided by book value. The cheapest 25% of firms are in the value portfolios and the most expensive 25% of firms are in the growth portfolios. The most profitable 25% of firms are selected in the profitability filters.
But a sharper sell-off among the most profitable small value firms means those companies now trade at a substantial discount. Since price and return are related, we believe this implies high expected returns for profitable small value going forward.
To evaluate this hypothesis, we looked at what happened following past market crises in Europe. Specifically, we looked at the six crises that have preceded COVID-19, from the Asian financial crisis in 1997 to the high-yield energy crisis in 2016. During each of these six episodes, high-yield spreads (a common “fear gauge” in bond markets) exceed 6%, which we consider to be the threshold for a market panic. In this study, we wanted to see what happened to small value and large growth (plus their most profitable segments) in the two years after high yield spreads hit 6%.
In the figure below, we plot European high-yield spreads over time since December 1997, when data begins from the St. Louis Fed. In the vertical bars, we highlight the six crises for which we have complete data to measure return outcomes over the subsequent two years (note that the first three crises had overlapping two-year horizons).
Figure 2: European High-Yield Spreads (Dec 1997 – Sep 2020)
Source: FRED, Federal Reserve Bank of St. Louis
Looking at equity returns over the two-year periods highlighted in the gray bars, we see that—on average—small value significantly outperformed large growth, and selecting profitable companies was beneficial in both strategies.
On average, profitable small value stocks returned 16.3% annualized over the two years following a crisis, significantly outperforming the 1.6% annualized return of profitable large growth over the same two-year horizons. Without a profitability filter, the broader small value category returned 11.1% annualized on average in the two years following a crisis, while the broader large growth category returned -0.9% annualized on average.
Evidently, it’s important to buy value stocks during crises, when bargains abound. And it seems especially important to buy profitable companies during these times of heightened uncertainty.
Figure 3: Post-Crisis Annualized Returns in Europe (Dec 1997 – Jun 2018)
Source: Ken French data library. Value is measured in terms of Price/Book and profitability is measured in terms of [EBITDA minus interest expense] divided by book value. The cheapest 25% of firms are in the value portfolios and the most expensive 25% of firms are in the growth portfolios. The most profitable 25% of firms are selected in the profitability filters.
We believe that investors can also outperform large growth through a simple “buy and hold” strategy in small value over the long run. Over the full horizon of our European study, from December 1997 to September 2020, small value stocks have compounded at 9.9% annualized, outpacing large growth by 4.8 percentage points per year. The profitable segment of small value has done even better, compounding at 11.7% annualized over the full horizon and outpacing profitable large growth by 5.5 percentage points per year.
Figure 4: “Buy and Hold” Long-Horizon Returns in Europe (Dec 1997 – Sep 2020)
Source: Ken French data library. Value is measured in terms of Price/Book and profitability is measured in terms of [EBITDA minus interest expense] divided by book value. The cheapest 25% of firms are in the value portfolios and the most expensive 25% of firms are in the growth portfolios. The most profitable 25% of firms are selected in the profitability filters.
History shows that buying highly profitable firms at low valuations has been a winning formula over the long haul. And with the most profitable small value companies in Europe trading at a deeper discount today compared to the end of last year, we believe these firms are poised for a significant rally over the course of an economic recovery.