The Great Equalizer
What happens when value grows like growth?
Small-cap deep-value stocks tend to suffer the worst in recessions, as macro-economic contractions hit smaller, cyclical firms harder and as financial market volatility tends to cause flight from illiquid assets, according to our research.
Yet, as we observed in our paper Crisis Investing, small-cap deep-value portfolios tend to perform the best coming out of recessions as the economy recovers and liquidity flows back in. A recent Research Affiliates paper found similar results looking at how factor portfolios performed in recessions and recoveries.
Figure 1: Strategy Performance in Recessions and Recoveries (US 1963–2019)
Source: Research Affiliates
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. As Eugene Fama and Ken French noted back in 2000, “negative changes in earnings and extreme changes seem to reverse faster.”
And, from our perspective, this reversal drove value stocks to show earnings growth rates higher than growth stocks in recoveries from past recessions. The same pattern seems to be holding today. Our friends at Factor Investor recently posted the analysis in the figure below of quarterly earnings expectations for growth and value stocks within the US S&P 500 index.
Figure 2: S&P 500 Q2 Earnings Growth and Forward Estimates for Value and Growth
Source: Factor Investor, Bloomberg. Figures are estimates except for this year’s second quarter.
In the United States, now that the Q2 earnings hit to value stocks has come out, analysts are expecting value stocks to grow earnings significantly more than growth stocks a year from now, according to the above figure.
We wanted to see if this phenomenon was a quirk of the last 70 years of US market history, so we performed a similar analysis in the biggest developed-world market outside of the US (Japan) for the data we have going back to the 1990s.
In Japan, during both the 2000 bubble and the 2008 crash, markets correctly anticipated that deep-value earnings would contract more severely than extreme-growth earnings in the short term. But deep-value stocks ended up growing earnings as fast as any other stocks in the long term.
Figure 3: LTM EPS Growth before, during and after Recessions
Source: Capital IQ. All Japanese stocks above $25M in market cap, excluding REITs and financials. Breakpoints for deep value to extreme growth are at the 10th, 50th and 90th percentile of market cap/revenue multiples for all stocks.
But, we noticed that for that same long-term EPS growth, deep-value investors paid 1/16th the amount per dollar of revenue in December of 2000 and 1/12th as much in December 2008 after markets first sold off.
Figure 4: Market Cap / LTM Revenue Multiple through Recessions
Source: See Figure 3. Dec 2000 and Dec 2008 were the first major selloff quarters in Japan.
And the consequences for returns were very similar to what we saw in the United States. After markets had sold off, we calculated that deep value outperformed extreme growth by 121% and 83% over three years, in 2000 and 2008 respectively, as shown below.
Figure 5: Returns before, during and after Recessions
Source: See Figure 3. Dec 2000 and Dec 2008 were the first major selloff quarters in Japan.
And while we don’t have a crystal ball to confirm that the next three years of factor returns will approach what we have seen elsewhere, we can see that the last quarter’s financial results look a lot like past recessionary contractions following a market selloff. Unsurprisingly, market participants have "correctly" priced in the short-term contraction for deep-value stock earnings compared to extreme-growth stocks.
Figure 6: LTM EPS Growth by Stock Valuation
Source: See Figure 3.
We’re not sure what could be so different this time around that would invalidate Fama’s 2000 observations about margin mean reversion. What is perhaps unique is that we have both a growth bubble and the first-quarter results of an economic contraction occurring simultaneously in the United States, Europe and Japan.
One need not believe that this global historical trend is explained by a behavioral fluke, short-termism or even by “just compensation” for the bumpy ride. This counter-cyclical deep-value strategy was closed to most sizable market participants at precisely the crisis moments when liquidity was prized the most within and across markets globally.
In the Japan examples above, the median extreme-growth stock was 15x larger than the median deep-value stock in 2000 and 10x larger in 2008: a welcome safe-haven of liquidity for larger allocators when global liquidity had dried up. Back then, deep-value stocks were very tight. With median market caps of $73M and $53M, respectively, it was easier for a camel to go through the eye of a needle than for a rich man to pursue the counter-cyclical deep-value strategies we described.
In our view, this is perhaps a more reassuring justification for why market participants seem to have left so much money on the table so consistently in the contractions of yesteryear and why they may be doing so again today. Despite all the unique causes, attributes and explanations of the particulars of each historical recession, these basic unifying conditions do not appear to have changed today.