The Great Equalizer Part II: Evidence from Europe

Around this time last year, we asked “what happens when value grows like growth” coming out of a recession? A year later, European equities have provided an answer.

By: Brian Chingono

The past two years have been a rollercoaster for investors, with the COVID drawdown in 1Q 2020, followed by a remarkable market recovery in the subsequent quarters. On the other side of this uncertain period, value stocks have come out ahead. Over the past two years, the MSCI Europe Small Value Index has compounded at a 15.2% annualized rate, outpacing the European market by 1.7 percentage points per year. The outperformance was even higher among deep-value companies that trade at cheaper valuations than the commercial index from MSCI. The Fama-French Europe Small Value Portfolio returned approximately 17.9% annualized over this period, outperforming the market by around 4.4 percentage points per year.

Figure 1: Annualized Return of Small Value vs. the Market in Europe (Oct 1, 2019 – Sep 30, 2021)

Sources: Ken French data library, Capital IQ, MSCI, and FTSE Russell. Note: since the Fama-French portfolio returns are currently only available through August 2021, we impute the September 2021 return by assuming the same return as the MSCI Europe Small Value Index in that month. Conclusions are not sensitive to the imputation in this single month (the annualized return of the Fama-French portfolio would be 18.1% if we had assumed the market return instead in September). Throughout this article, the term “FTSE Europe Market Index” is an abbreviation for the FTSE Developed Europe All Cap Index.

As we have written before, value investors earn a premium for staying the course. And we believe we’re still in the early innings of a gradual rotation toward value, given today’s historically wide valuation spreads. A key driver of those valuation spreads is the divergence in expectations about value stocks relative to the market. Investors typically expect lower earnings growth from value stocks compared to the large growth companies that dominate market indices. Yet coming out of recessions, value stocks often grow their earnings at a faster rate than their expensive peers, as cyclical value companies lead the recovery. This has been the case yet again in the most recent recovery, as small value stocks have grown their earnings at a higher rate than the market over the past year. Although the Fama-French index does not disclose underlying holdings, we can see the earnings picture by comparing the MSCI Europe Small Value Index against the FTSE Europe Market Index. Over the past year, European small value companies in the MSCI index grew their EBITDA by 27%, outpacing the market average of 23% earnings growth over the same period. This earnings outperformance is consistent with what we wrote at this time last year:

“Perhaps the most significant—and surprising—reason that value stocks outperform coming out of recessions is high earnings growth rates: growth rates that often exceed the growth in more expensive, glamour stocks.”

Figure 2: European Earnings Growth over the Past Year (6/30/2021 vs. 6/30/2020)

Sources: Capital IQ, MSCI, and FTSE Russell

Not only did small value stocks outperform the market on earnings growth, they also deleveraged at a higher rate. The figure below shows the proportion of leveraged companies that paid down some debt over the past year. Within the small value index, two-thirds of the leveraged companies paid down debt over the past 12 months. On the other hand, only about half of the levered companies in the market index paid down debt.

Figure 3: Deleveraging in Europe over the Past Year (6/30/2021 vs. 6/30/2020)

Sources: Capital IQ, MSCI, and FTSE Russell

As we have written previously, deleveraging is predictable and contributes positively to returns. So the two-thirds base rate in the small value index would have been improved upon with analytical tools that forecast debt paydown, providing further incremental returns. And going forward, we believe the biggest contributor to small value returns will be a gradual narrowing of valuation spreads from the extremely wide levels recorded last year. In 2020, the spread in valuations between cheap and expensive companies in Europe reached its widest level on record since 1975. As these valuation spreads gradually revert to their historical averages, we believe that mean reversion will provide a powerful tailwind for small value returns in Europe over the next decade.