Small Value – One of These is Not Like the Others

Heard enough already about value’s underperformance and why the evidence suggests staying the course?  Just in case not, we will live our relational investing¹ principle of stating where we stand and briefly summarize our research on value overall in the US market.  More importantly, we will move from Wall Street down a different street with a focus on US small-cap value for a discussion of One of These Is Not Like the Others².

Overall US Value

Looking at the US stock market back to 1926³, it’s pretty obvious to see that One of These (Columns) Is Not Like the Others. In general, over the entire period of history, the right most column with the deepest value exposure has had distinctly higher returns than others.

US Stock Market Since 7/1926 (Annualized, %), as of 9/30/2020

	Growth	Mid-Gro	Mid	Mid-Val	Value
Big	9.97	9.54	10.27	8.65	10.44
Med-Big	10.38	10.76	11.61	12.37	11.62
Medium	9.21	12.28	12.22	13.37	12.66
Med-Sml	7.55	11.77	12.48	13.06	14.29
Small	2.62	6.67	11.04	13.86	15.39

Source: Bridgeway, Ken French data library⁴, total US stocks formed into 25 portfolios based on size exposure defined by market capitalization and value exposure defined by price to book ratios.

For most value investors though, the past one, five, and 10 years has proven instead that One of These (Time Periods) is Not Like the Others. Notably, the results in the most recent decade are the opposite of the results back to 1926.

US Stock Market Last 10 Years (Annualized, %), as of 9/30/2020

	Growth	Mid-Gro	Mid	Mid-Val	Value
Big	18.11	13.41	11.62	7.24	7.48
Med-Big	16.66	13.73	10.29	7.98	6.45
Medium	13.72	14.06	9.34	10.42	3.47
Med-Sml	14.60	13.03	9.78	6.76	6.86
Small	7.92	12.12	8.27	7.83	7.66

US Stock Market Last 5 yr (Annualized, %), as of 9/30/2020

	Growth	Mid-Gro	Mid	Mid-Val	Value
Big	21.75	13.31	9.72	2.70	4.94
Med-Big	18.48	12.98	9.17	0.36	1.80
Medium	13.21	11.14	6.57	7.09	-1.52
Med-Sml	15.80	12.89	6.79	1.25	3.35
Small	12.19	11.60	7.84	3.49	4.20

US Stock Market 1 Year (%), as of 9/30/2020

	Growth	Mid-Gro	Mid	Mid-Val	Value
Big	40.83	13.57	-2.01	-20.60	-16.12
Med-Big	33.35	8.53	-4.78	-18.65	-26.69
Medium	22.64	14.73	-12.12	-6.20	-26.65
Med-Sml	27.58	4.78	-8.38	-22.00	-10.05
Small	31.49	30.96	2.44	-15.21	-8.49

Source: Bridgeway, Ken French data library⁴, total US stocks formed into 25 portfolios based on size exposure defined by market capitalization and value exposure defined by price to book ratios.

Based on the long-term evidence, the long and deep drawdown of value in the US is not surprising (though it’s still not fun). It has happened before with value, the overall stock market, and other factors.  While challenging to endure, underperformance provides confirming evidence of exposure to different sources of risk that investors should seek. Put another way, this underperformance is a manifestation of the “risk” portion of “risk premium” that ultimately has been rewarded; the higher historical returns of value are not a free lunch and require a strong stomach. 

On the positive side, historical evidence for value gives us optimism for the coming decade.  In the US, value⁵ has outperformed growth⁶ 91% of the time over rolling 10-year periods going back to 1926.  Over those same periods, the US stock market⁷ has only outperformed the risk-free rate 86% of the time; thankfully, investors don’t typically question the benefits of staying the course with stocks over cash, and we believe the same holds for staying the course with value stocks.

We don’t know when value will recover, but when it does, history shows it has typically been strong.  Long-term evidence for the US shows that not only has using deeper value exposure and multiple measures produced higher returns when times are good, but also has helped in drawdowns and recovery.  For more on value overall, see Factoring in Bear Markets, Stress Test: How Factors Perform Before, During, and After Recessions, Value’s Defining Moment or Does Value Just Need Some Growth?, or email advisors@bridgeway.com.

A Deeper Look Into US Small Value

So, what about small-cap value in the US?  As with value in the market overall, the results for small-cap value over the last decade are starkly different than long-term results back to 1926. 

As the tables above and chart below shows for the period back to 1926, there has been a 2.33% annualized benefit in return for the very smallest and most value companies (15.39%) shown in the bottom row and last column of each table, compared to the next smallest and next deepest value companies (13.06%) shown in the fourth column and fourth row of each table for almost 95 years.  On the other hand, for the last 10 years, the benefit was only 0.90% annualized for the additional small value exposure even after including a 13.51% advantage in the last year. 

Source: Ken French data library and Bridgeway calculations. See disclosures for more information.

This concept is important to remember as we think about if One of These (Portfolios) Is Not Like the Others. The variation of returns reminds us that the level of capitalization and value exposure truly matters even among different small-cap value strategies. 

When a segment of the market does well, investors should expect the portfolio with the most exposure to the factors explaining the segment’s outperformance to have the highest return. And when a segment of the market does poorly, investors should expect that same portfolio with the most exposure to the factors will underperform.  

Performance across small-cap value portfolios can diverge significantly, particularly when the asset class is either doing significantly better or worse than the overall US market.  This has definitely been the case over the last decade.  Divergence is usually driven by meaningful differences in size of companies held, valuation of companies held, measures of value used, and differences in allocations across sectors like REITs and utilities. These performance differences rarely indicate that a portfolio is not efficiently delivering the expected returns. Instead, performance differences arise because of differences in portfolio design. A portfolio focused on the stocks with smaller size and deeper value will indeed not look like other small cap value portfolios lacking that depth of exposure.

Conclusion

So, as we sit in one of those periods that has not been like the others, what can investors do? We at Bridgeway focus on the intersection of what matters and what we can control and have discovered the power in the paradox that often the best thing for investors to do is “very little”

As leaders in relational investing, we suggest being guided by principles and staying invested in your outcome.  Diversification is a crucial concept for all investors, and for Bridgeway it includes not just the way we invest but also how we run our firm and the people we hire.  We do not make dramatic changes to our portfolios because we are in a pandemic, recession, bear market, or other challenging time, and we think all investors should avoid the temptation. These moves are potentially costly in terms of trading needed to implement those changes and the substantial risks of not getting that timing call exactly right.

For a PDF download of this thought piece, please use the following link:

http://bridgeway.com/wp-content/uploads/2020/11/Bridgeway-One-Is-Not-Like-The-Others-THOUGH-PIECE-1.pdf

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