Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
Unloved value stocks primed for outperformance: Pzena
The equity risk premium – the prospective potential return for stocks relative to bonds – can swing from extremely low, like when Treasury yields sat at 15 per cent in the early 80s, to very high, as in the depths of the GFC when bond yields were only moderate. With yields now approaching five per cent, investors have rightly asked whether the risk-reward trade-off of equities still makes sense.
But value stocks have historically “flourished” in low ERP periods, according to Pzena Investment Management, and show all the signs of doing so again.
“We have record levels of concentration in the index that is mathematically driven by a small number of very, very expensive stocks, which is skewing the overall market,” Pzena portfolio manager Daniel Babkes told a client webinar. “That’s the starting point of that cohort, which tends to do not so well in this environment, while value tends to perform better in an environment where the starting point is this cheap relative to other asset classes.”
Pzena’s work on the ERP and what it means for five-year forward returns across sixty years of data found that in periods with an exceptionally low ERP, bonds do tend to outperform stocks by an average of 60 basis points.
“But this is really the important point: that’s been driven historically entirely by substantial underperformance of expensive stocks,” Babkes said. “When we look at the expensive cohort of stocks when you’re in these periods of low ERP, they underperform bonds by around 250 basis points annually.”
Not so for value stocks, which “actually perform great” in the same environment. The Pzena hypothesis for that is their superior earnings yield.
“History says that in periods where there’s a low ERP, value stocks outperform bonds by more than 500 basis points annually even though the overall market may not provide the greater return.”
They didn’t receive any tailwinds during the period of multiple expansion over the last cycle, either; the high flyers have gotten to record valuations, while stocks in the area where Pzena plays hasn’t gotten any.
“You have a market that looks expensive when you take into account the concentration levels we’re at today, but the spread between what’s loved – which is driving the market valuation, the loved stocks are more loved than they’ve been on average historically – and the value stocks we look at are just as distrusted as they’ve ever been and presenting pretty good opportunity for double-digit earnings yields going forward,” Babkes said.
