by Melissa Duller, Wells Fargo Asset Management
Today we have a joint blog post from Dr. Brian Jacobsen, CFA, CFPÂź and Melissa Duller, CIMAÂź
Investors value different attributes at different periods of time. However, most people think of value as it relates to a companyâs earnings. From the 1920s through the early 1990s, it was well believed there was a value premium. This means lower-valuation stocks based on price/earnings (P/E) ratio outperformed higher-valuation stocks. In the chart below, note how much money investors would have made buying lower-valued stocks versus higher-valued stocks over the past 15 years.
(Note: P/E ratio is based on the average of analystsâ expectations of a companyâs earnings per share over the next 12 months.)
In the past three years, however, this dynamic has changed. In six of the past seven quarters, high P/E stocks have outperformed low P/E stocks. Apparently there hasnât been much value in value. There appears to be cyclicalityâor something akin to fashion fadsâto what performs better: low or high P/E. Low P/E stocks outperformed markedly in periods such as 2003â2006, 2009, 2012, and 2013. Looking at rolling two-year performance spreads, low-valuation stocks have underperformed by the widest margin in 10 years.
Underperformance of low P/E stocks isnât just a phenomenon among U.S. large cap stocks. Hunting for value in low P/E stocks just hasnât worked, whether youâre looking at U.S. large- or small-cap, value or growth, or in foreign markets.
Since the fourth quarter of 2014, when expensive stocks began outperforming cheap ones, the expansion of the P/E multiple has been much more significant for expensive stocks (quartile 1) and can account for their outperformance. By contrast, cheap stocks have not had an increase in P/E multiples to date.
How much can performance be explained by multiple expansion?
| Since P/Es last troughed (Q4 2011) | Since high P/Es began outperforming (Q4 2014) | |||||
| Change in P/E | Cumulative return | Percent of return resulting from multiple expansion | Change in P/E | Cumulative return | Percent of return resulting from multiple expansion |
|
| Most expensive stocks | 64% | 96% | 66% | 20% | 19% | 103% |
| Cheapest stocks | 55% | 102% | 54% | -5% | 1% | 0% |
| S&P 500 Index | 57% | 113% | 50% | 9% | 15% | 65% |
Sources: FactSet, Zephyr
S&P 500 Index used to create âcheapest stocksâ (P/E NTM quartile 4) and âmost expensive stocksâ (PE NTM quartile 1) groupings.
What investors should remember
Looking for undervalued companies (low P/E stocks) with such attributes as improving fundamentals, strong balance sheets, experienced management teams, and well-positioned products that should exhibit price appreciation hasnât been rewarded. However, it appears that trend may be changing. Itâs early, but in July and thus far in August, lower-valuation stocks outperformed higher-valuation stocks. If history is any guide, when these trends turn, they can turn for a while.
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