Don’t Call it a Comeback – The Return of Small Value


So far in 2020, and really for the past few years, investing has seemed pretty easy.  Invest in the big, well-known companies that everyone has heard of and uses, and you outperform the rest of the market and probably most professional investors.  Historically, investors have realized a premium in terms of risk-adjusted outperformance by investing in smaller and more value-oriented stocks.  However, the last 3 years the exact opposite has been true.  As the chart below clearly shows, the more one invested in small and/or value stocks, the worse their performance.

The obvious question to ask is why this happened, and if it should change our expectations going forward.  Diving deeper into valuations, there are only two things that can cause a stock price to go up:

1.) The fundamentals of the company increase.  This is generally defined by some measure of profitability one can discover from looking at a company’s income statement (ie. Cash Flow, Earnings etc.). This is pretty intuitive; as a company’s profitability increases, the value of that company increases and hence the stock price goes up.

2.) Investors are willing to pay more for the same fundamentals.  This is measured by valuation multiples suck as Price-to-Earnings (PE Ratio), Price-to-Cash Flow etc.

Conventional wisdom states that over the long-run, while those multiples will fluctuate, a stock’s value will only increase as those fundamental measures of profitability increase.  For any one stock and/or for any short period of time, this does not tell us much useful information.  However, when looking at the aggregate of a whole bunch of stocks (say Large US Growth stocks) and stretching out our time horizon, this can actually be a lot more meaningful. Below is a graph of two of these multiples over the last 70 years.

What stands out here is that when we look at the run up in stock prices over the last several years, we can see that a significant portion of the price increase comes from our 2nd group – investors are currently willing to pay more for a relative level of profitability than at any point in the last 70 years.  The only comparable time was right at the top of the tech bubble near the turn of the century, which was followed by a massive sell-off and subsequent decade of significantly negative stock returns.

Bringing this back full circle, it’s unsurprising that during this time when investors were pouring money into these large growth stocks without commensurate fundamentals, they were largely ignoring small value stocks.  The below graph shows outperformance (or underperformance) of large growth stocks relative to small value stocks over rolling 5-year periods since 1926.

The blue line here is simply the annualized return of Large Growth minus Small Value for the previous 5 years.

The most eye-catching feature of this graph is just how uncommon it is that large growth stocks have outperformed small value stocks over 5-year periods (these are time periods where the blue line is above the red line) and how massively it has underperformed for many of these periods.  In fact, small value has performed better 68% of these periods.

The other striking feature is that the current 5-year period represents the largest outperformance by large growth stocks in the 95-year history.

So where do we go from here?  In the current period large-growth has beat small value by 16% per year.  There are 100 other months in this time series where large growth beat small value by at least 5% per year over the previous 5 years.  I graphed these years in order of magnitude, and then looked at what the performance looked like the NEXT 5 years. Not knowing exactly what to expect when I ran this data, the results were pretty astounding.

Almost every one of these periods of large-growth outperformance were followed by a period of even greater small-value outperformance.  Over these 100 data points, small-value returned on average 17.4% per year better than large-growth over the subsequent 5 years.

We never know when one cycle ends and the next begins, but history has shown us that it inevitably does happen, and when it does, the opportunity can be massive.  In the last few days, we’ve seen a huge swing in performance, with small-value stocks staging an impressive comeback, making up over 13% in just 3 days.

Maybe we’ve seen the inflection point and this trend continues, or maybe this doesn’t age well and large-growth stocks have some legs left in their rally.  It’s a fools errand to make short-term predictions on these things, but it’s also unwise to ignore where we stand right now through the lens of history.

Planning and advisory services provided through Keystone Wealth Partners, LLC , a  federally registered investment adviser under the Investment Advisers Act of 1940. Registration does not imply Information a certain level of skill or training.  More information about Keystone can be found by visiting and searching by the adviser’s name. This is prepared for informational purposes only and may not be applicable to your particular situation or need(s). It does not address specific investment objectives.  Information in these materials are from sources Keystone Wealth Partners, LLC deems reliable, however we do not attest to their accuracy.  Past performance is not indicative of future results.

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