One of the most enduring experiences in all of investing is the tendency for the lowest-priced “value” stocks to outperform higher-priced “growth” stocks and the overall stock market (S&P 500), which is dominated by the largest and highest-priced stocks. As you’ve heard me say countless times, whether your goal is to retire comfortably (and as soon as you can), generate more income in retirement, or leave a bigger legacy behind, emphasizing the lowest-priced value stocks in your portfolio and staying with them through thick and thin is the surest path to success.
For almost a century, the return for large value stocks has been +1.5% a year over the market (S&P 500), and small value stocks have generated +4% a year higher returns:
But this return “premium” for holding value stocks has been noticeably absent in recent years, which has been frustrating for Servo clients because we emphasize these lower-priced stocks in our portfolios both in the US and international markets. From 2017 through 2020, while the returns on the S&P 500 have been well above average, large and small value stocks have been disappointing. When you expect a long-term return of 12% to 14% per year, based on the historical data, and 1% to 3% a year more than the market, the numbers below can be like a kick in the gut…
The premium returns for value stocks don’t show up every year or even every few years. The odds are high that the value premium will be positive, even over yearly periods, but it’s not guaranteed. A short-term spell where value stocks underperform is to be expected, quite often when the largest growth stocks are doing very well. This is the other side of the story for including large and small value stocks in a long-term portfolio: you get a diversification benefit…sometimes when the market is doing well you will see your value stocks doing poorly, and sometimes when the stock market is struggling you will see your value stocks doing much better.
I’ve tried to remind clients that the years leading up to 2017 looked like a mirror image of recent times, in which the S&P 500 and large growth stocks in general did very poorly while value stocks performed much better. From 2000 through 2016 — almost two decades (!!!) — large value stocks beat the S&P 500 by over 2% a year and small value stocks outperformed by over 7% a year! Is it so hard to believe, then, that the value premium would take a few years off?
Of course, “a few years off” is a bit of an understatement, value stock returns compared to growth in recent years have been among the worst in all of history. There’s a reason why staying the course and not second-guessing our decisions has been so difficult! You’ve never had to put up with a greater amount of short-term relative underperformance.
It is for this reason I would like to update you on the recent returns for the S&P 500 and value stocks. As I mentioned in the Q4 letter and in upcoming newsletters, the tide has turned (for how long we can never say) in favor of value stocks. Hopefully, even this short-term reprieve should be of some consolation for you. Despite a disappointing year overall on a relative basis for value stocks, they ended the year on a very high note and have shown no signs of slowing down in 2021:
Morningstar reports that since October 1st of last year, through yesterday, while the Vanguard S&P 500 Fund (VFINX) has done well, up +13.95%, the DFA US Large and Small Value Funds (DFLVX and DFSVX) have done considerably better — gaining +28.96% and +55.77%, respectively. A +41% advantage for small value stocks over the S&P 500 in less than six months is astonishing, and once again illustrates why it is so important to stock to your asset allocation and rebalance; big returns (and return premiums) can come when you least expect them!
This is just a few months, so where do we stand since the market bottomed last Spring? We know value stocks were hit much harder during the Covid-lockdown bear market, but in most bear market recoveries, smaller and more value-oriented stocks tend to lead the way. Was this even possible — that small value stocks would outperform in the recovery — given that many of these companies had been disproportionately decimated by the economic plunge or were forcibly closed by our government while the big tech stocks that dominate growth portfolios actually benefited from Covid? More than one client told me they thought “this time was different” (still the four most expensive words in the English language).
No, it has not been different. Diversified investors who gutted out the record plunge in Feb/March of last year and stuck with their value stocks have been handsomely rewarded. While the Vanguard S&P 500 Fund (VFINX) is up +73.75%, the DFA US Large Value Fund (DFLVX) is up +84.00% and the DFA US Small Value Fund (DFSVX) has jumped +131.41%. Small value stocks have almost doubled the return on the S&P 500. Just as history would have predicted.
What does the future hold for value stocks? Will they continue to surge or is it time for a breather after 11 months of over 60% higher returns than the market? Unfortunately, no one can say for sure. In re-establishing expectations, your best bet is to return to the first chart I included above. It shows about a +10% return on the stock market, almost +12% a year for large value, and over +14% a year for small value. Your long-term returns will probably be close to these figures. While the absolute results could be lower (let’s say +8%, +10%, and +12%), the relative spread between value and growth is likely to be similar if not higher — today value stock valuations are still very reasonable and within earshot of their long-run average, while large growth stocks are as expensive as they’ve ever been.
But regardless of what happens in the short run, hopefully you can rely on this recent experience as a reminder that there is considerable value in sticking with value stocks!
Past performance is not a guarantee of future results. Index and mutual fund performance includes reinvestment of dividends and other earnings but does not reflect the deduction of investment advisory fees or other expenses except where noted. This content is provided for informational purposes and should not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services.