What Works in Europe
Political uncertainty in the EU has led to significant outflows from European stock markets in 2018, leaving European equity markets trading at a significant discount to the United States. In our past few research notes, we have argued that these political risks are overstated—and that the discounted valuations present a buying opportunity.
The greatest risk cited by analysts about European stocks is that countries might leave the EU or the Euro currency, thereby “destabilizing” the markets. The implicit assumption behind these fears is that EU membership or adoption of the Euro currency is somehow good for a country’s equities. But since the EU was established in 1993, EU-member countries have not delivered higher equity returns than non-EU countries in Europe. Within the EU, countries that adopted the Euro currency have not outperformed countries that chose to keep their own currency. And, in retrospect, expert concern about the impact of Brexit on the United Kingdom was significantly overstated.
We have spent the past year studying the last three decades of European equity markets to develop Verdad’s strategy, focusing on understanding which types of stocks perform best and how to maximize returns by choosing an effective reference class of stocks.
The Chicago School of quantitative investing, pioneered by Eugene Fama, established the idea that small, cheap, profitable companies outperform over the long term. To start our analysis, we looked at how size, valuation, and profitability predicted equity returns in Europe from 1990 to 2018.
In Figure 1, we show the returns of small-cap and large-cap European stocks sorted into five quintiles based on their valuation and operating profitability. Group 5 contains the cheapest and most highly profitable stocks, and Group 1 contains the most expensive and least profitable stocks.
Figure 1: Value Premium and Profitability Premium in Europe by Size Segment (1990–2018)
Source: Ken French data library and Verdad analysis
There are three important takeaways from Figure 1. First, value stocks have delivered higher returns than growth stocks, and highly profitable firms have outperformed low-profit firms over the past 28 years in Europe. Second, the magnitude of the value premium and the profitability premium are significantly higher among small stocks than among large stocks. Third, the premiums are much more reliable among small stocks than large stocks. T-statistics of the value premium and the profitability premium are 3.71 and 8.79, respectively, among small stocks; well beyond the minimum threshold of 2.
The evidence suggests that small cap stocks offer a better fishing pool for investors in Europe, and that value and profitability characteristics are important considerations when forming a portfolio.
How would a strategy that combines value and profitability premiums compare against the market over time? Figure 2 answers this question using European return data from June 1990 to July 2018. The small-cap strategy that combines value and profitability delivered a 13.8% annualized return over this period, while its large-cap counterpart delivered an 11.8% annualized return. Both strategies outperformed the European market return of 7.5% per year. Consistent with earlier observations, the premium was larger and more reliable among small-cap stocks.
Figure 2: Combined Value and Profitability Premiums vs. the European Market (1990–2018)
Source: Ken French data library and Verdad analysis
Relative to the large-cap strategy, the small-cap strategy delivered greater outperformance without increasing risk. The volatility of the small-cap strategy was 20.8% versus 23.4% in the large-cap strategy.
These premiums are well understood in academic literature. Our unique contribution is the insight that investors can improve their returns even further by focusing on the small, cheap, profitable stocks that have debt on their balance sheet and are in the process of paying down that debt.
Debt on the balance sheet amplifies equity returns. Take a company worth $100 that is unleveraged: a 10% increase in the value of the company means a 10% increase in the value of the equity. In contrast, take a company worth $100 that is financed with $90 of debt and $10 of equity: a 10% increase in the value of the company means a 100% increase in the value of the equity.
Paying down debt with cash flow creates equity value mechanistically. If the hypothetical company worth $100 financed with $90 debt and $10 of equity decided to pay down $10 worth of debt, the equity would now be worth $10 more. But this also often leads to higher valuations due to the reduced risk of bankruptcy, lower future interest payments, and improved financial health.
For these two reasons, leveraged small value stocks have had higher returns historically than unleveraged small value stocks. Figure 3 presents the returns of a leveraged small value strategy that selects 50 small, cheap, profitable, and leveraged European stocks in each year between June 1997 and December 2017. We compare the returns of this leveraged small value strategy against the small value & profitability index and the market index in Europe.
Figure 3: Leveraged Small Value vs. Small Value Index and Market Returns in Europe (1997–2017)
Source: Ken French data library, CapitalIQ, and Verdad analysis
As suggested by the results in Figure 3, leverage amplifies the benefits of value and profitability, thereby providing the potential to outperform the market by a wider margin. Interestingly, leveraged small value outperforms without an increase in risk relative to the broader universe of small value stocks.
Private equity firms in Europe have bought companies with a similar financial profile—small, cheap, and highly leveraged—and produced gross returns that look comparable to our leveraged small value strategy. We believe that buying leveraged small value stocks in the public market provides a more liquid, lower-fee alternative to private equity that more efficiently maximizes the factor exposure to value and profitability.