The income arena may be where some of the asset class's current woes are located. Value businesses are expected to reward investors with higher yields in return for slower rates of growth. In the 1980s, this translated into about 2 percent addiional yield annually.
As the entire market has become more expensive however, "the yield advantage of cheap companies wanes," assuming their discounts relative to the market remains similar. That means their "yield advantage" is no longer as attractive. Therefore, income becomes a smaller driver of positive relative returns.
What about rebalancing? Pease uses the example of Jack Welch's 20-year tenure at GE, which he attempted to transform from an old-fashioned value company into a growth engine. At the helm of a conglomerate with a vast portfolio of divisions, he sold or jettisoned slow growing and underperforming businesses and reinvested in companies with growth potential.
After his first decade at GE, Welch had mesmerized Wall Street and was rewarded with a high multiple stock. At that point, he was able to go into the market and acquire lots of low-growth, cheap insurance carriers using pricey GE shares. The transactions were accretive to earnings and fueled profit growth. GE was essentially a financial and industrial conglomerate masquerading as a growth company selling at 30 times earnings and Wall Street fell for it hook, line and sinker.
Many believe that GE and others failed to realize the long tail liabilities associated with many of these insurers, particularly with long-term care insurance. Welch's management of GE (and his successor Jeffrey Immelt) has become controversial in recent years, largely because of issues relating to questionable accounting. Pease doesn't address those problems.
What he explores is the "replacement process," where a "formerly disappointing company sees its fortunes change" and its share price responds. In the last decade, Microsoft's turnaround following the replacement of CEO Steve Ballmer is another example.
Microsoft's experience aside, "rebalancing has disappointed somewhat" since 2005, Pease concludes. While portfolio turnover—or companies moving from value to growth and vice versa—has been significant, it isn't "benefitting investors as much as it did previously."
Three possible factors explain this phenomenon, Pease's view. Stocks simply are rotating less between value and growth, the valuation gap "between securities exiting and joining the value group becoming more compressed," and the correlation of rotation volume and valuation spreads are dropping.
The real question is why and Pease concedes it may be a question for another day. But among the possible answers are growth companies are enjoying more sustainable profitability, lending "credence to the fundamental shift theory," and there has been a slowdown in the number of takeovers of cheap companies.
The Carl Icahn's and Bill Ackman's of the world are now activists, not takeover artists. All other things being equal, that means they don't believe that managements of companies with low valuations are so incompetent that an outsider can easily improve results. In the 1980s, corporate raiders were confident they could increase shareholder value even if they knew little about the mechanics of the underlying businesses.