The final theory—nothing really has changed—is what value investors would love to hear. Given that economic and market cycles are much longer today than they were in the mid-20th Century, this perspective may have some merit. As Pease notes, “giving up on value” after an extended period of poor performance could turn out to be terrible timing.
What are Grantham Mayo’s conclusions? The good news for value investors is that “atypical undergrowth is not the culprit.” Value stocks are not performing worse than they have in the past when judged by fundamental investing metrics.
Instead, the blame should be attributed to the other three drivers of return, though not equally.
As valuations across all sectors have risen, Pease notes that “income differentials have waned” and yield have become compressed. Growth companies have enjoyed more persistent profitability and higher multiples, “leading to fewer new value opportunities.”
Are value investors in for another rough decade? Pease acknowledges that the value premium may not be as pronounced “as it has been in the past.”
But today value’s “discount is wide.” And while one can find numerous reasons “for value to trade at a greater discount today,” their current huge discount leaves these stocks positioned to deliver excess returns.
Why have they lagged so much for the last 13 years? One factor is turnover, or what GMO terms the rebalancing effect. That occurs when value investors sell stocks that have become more expensive and buy cheaper stocks. “The changes in multiples to the value cohort underestimate the true gains reaped by investors from multiple expansion,” Pease writes.
In the 1981 to 2005 period, this rebalancing effect provided almost 4 percent of returns. Over the last 13 years, this driver of returns has shrunk by 0.6 percent.
In the last decade, the biggest challenge for companies in a low-growth, low-inflation world has been generating top-line revenue growth. Has the gap in top-line growth between value and growth widened? No, according to Pease. Companies in the value universe continue to trail growth companies by about 3 percent a year.
Has the quality of their earnings deteriorated? Not at all. If anything, Pease declares the quality of value companies' profits are higher than they were in the 25-year period up to 2005.