U.S. equity market valuation spreads suggest a value resurgence

Value indexes handily outpaced growth indexes in every global region in 2016, a trend we believe is worth noting. Our research suggests that a significant opportunity is in the offing for deep value investing, given the length and durability of previous value cycles and the significant width of current valuation spreads.

As value investors, we're focused on owning a portfolio of stocks that's cheap relative to a broad universe of stocks that's currently considered very expensive. The price-to-earnings ratio of the S&P 500 Index has recently risen to historic levels—stock prices at more than 22 times trailing earnings as compared with just over 17 times earnings for the 5-year and 16 times earnings for the 10-year period—although earnings are expected to grow for a third consecutive quarter following six consecutive quarters of declines.¹

Equity valuations have been at extremes for some time—cheap cyclicals and expensive dividend payers and bond proxies—and this divergence has been a hindrance for active managers, as volatility and fear have been driving the markets. Our research indicates that when spreads widen significantly, the excess return potential for value investors has been significant. The valuation spreads between the cheapest stocks and the most expensive stocks are at levels last seen during the tech bubble in the late 1990s and are among the widest spreads witnessed in the past 50 years.²

Our analysis suggests that deep value stocks are likely to outperform when valuation spreads cross one standard deviation, and we're currently measuring more than two standard deviations.³ Value stocks have outperformed 13 out of 14 times in subsequent three-year periods and 11 out of 13 five-year periods when spreads have become outsized. In the United States, on average, value stocks have experienced outperformance of 44% and 71% over the three- and five-year periods, respectively, following a turn in the value cycle. These stocks have only gained about 21% since the cycle turned to value in February 2016, which gives them a great deal of room to grow, considering the average of 161% produced over the full value cycles.²

Our analysis shows that pro-value cycles have lasted an average of 72 months since 1973. While we can't be certain if we're experiencing a true rotation to value, we believe there's significant opportunity embedded in the valuations of deep value stocks relative to the broad market.

We see opportunity in the financials sector, as valuations for many of the companies we've targeted don't reflect improving economic conditions or the numerous operating improvements completed by these companies. This self-healing process has led to improved profitability, and the potential for regulatory reform could benefit companies in this sector. Also, we've invested in mature information technology businesses that are making the transition to cloud computing, and we favor diversified integrated energy producers that should generate increased cash flow from the commencement of major projects that were previously on hold.

1 FactSet, as of 3/16/17. 2 Pzena Investment Management, as of 12/31/16. 3 Standard deviation is a statistical measure of the historic volatility of a portfolio. It measures the fluctuation of a fund's periodic returns from the mean or average. The larger the deviation, the larger the standard deviation and the higher the risk.