The time for value?
Low price to earnings (P/E) and low price to book (P/B) are two of the most common ways to express value as a factor. Notwithstanding the value rally in the second half of 2019, stocks that look cheap on these metrics continue to look cheap — perhaps for a reason. Value factors like low P/E and low P/B omit any consideration of a company’s debt. And companies screening well on these metrics often employ high balance-sheet leverage, which can make value factors more sensitive to a cyclical slowdown — a risk that may have receded somewhat but has not fully abated. We consistently hear about balance-sheet strength from fundamental managers, who seek to weed out stocks most levered to the risks presented by the current market environment. One approach some adopt is to look to expressions of value that don’t reward companies for leverage such as enterprise value to free cash flow (EV/FCF).
Value strategies also typically rely on mean reversion in a company’s profitability (i.e., below-trend profitability returning to its average). This implies that for a value strategy to work, there needs to be some volatility in company profitability across the market. However, in the past decade we’ve seen the persistence of profitability steadily increase (Figure 1). This structural challenge for value has been especially acute in the US, where not only is the serial correlation of profitability high, but the spread between the most profitable and least profitable companies has also been widest.
Japan faces a different problem: Profitability is generally lower there and the spread between the most and least profitable companies has historically been narrow. While the spread is still narrow relative to the rest of the world, it has started to widen. In 2013, Prime Minister Shinzo Abe launched a radical program of monetary easing and corporate reform. While monetary easing poses a structural challenge for those value factors dominated by banks (e.g., low P/E and low P/B), structural reforms have incentivized stronger corporate governance. Against this backdrop, the stocks that have outperformed the most have been those associated with higher profitability. We expect this to continue. Pre-Abenomics, this was anything but the norm.