2015 Annual Review: Where is the Value Premium?

Most investors will accept the premise that risk and return are related: the higher the risk, the higher the potential return. Value companies are riskier than growth companies and therefore carry a higher return premium.

There are a few characteristics that define a value stock, but the most consistent over time can be book value multiple. A firm trading at less than double its book value can be considered a value company while a firm trading at more than double its book value can be considered a growth company. A reason value companies trade at lower book value multiples is because of market concerns that make them less attractive – or riskier – to potential investors. Being less attractive leads to less demand that in turn leads to lower share prices. Investors buying these riskier low priced securities should be rewarded with higher returns over time, so the reasoning goes.

Indeed, looking at the long-term data this is exactly what we see. Viewing our Quarterly Investment Update for Q4 2015, value has generated an additional 3.13% per year in Canada versus growth over the last 20 years. Longer time periods yield even larger value premiums. Similar results can be seen in U.S. and international markets.

However, in more recent years the value premium has been absent. In fact, over the last three years, value has underperformed growth by 4.75% per year in Canada. In 2015 alone, value underperformed growth by 6.45%. Again, similar results are observed in U.S. and international markets.

Does this mean we should throw in the towel and jump on the growth bandwagon? Of course not. Expecting the value premium to be completely predictable and present each year would be foolish. In fact, if it were, any additional returns would be arbitraged away immediately.

Even more, long-term periods of absent value premium are nothing new. In the U.S., almost one third of all rolling 10-year periods have seen negative value premiums[i]. The key is to have a diversified portfolio that includes exposure to both value and growth companies. This strategy will allow investors to capture a portion of the value premium while maintaining some growth exposure so they participate in periods where growth outperforms value.

Remember the dot-com bubble? This was the latter part of a period where growth stocks outperformed value by over 2% per year for 10 years.i After the dot-com meltdown, during a four-month period from November 2000 to March 2001, value stocks outperformed growth stocks by an incredible 35%.[ii]

The lesson here is to remember that things change unpredictably. Sticking with a diversified investment philosophy that is backed by decades of academic research should pay dividends in the long run.

[i] Russell 3000 Value Index minus Russell 3000 Growth Index, Enterprising Investor, Dougal Williams, CFA Institute, 2015-12-15

[ii] Enterprising Investor, Dougal Williams, CFA Institute, 2015-12-15

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