From 1928–2017, the value premium in the US had a positive annualized return of about 3.5%. In seven of the last 10 years, however, the value premium has been negative.
Is this extended “underperformance” a cause for concern?
To risk or not to risk? The value premium can help guide investors
Here’s a quick tutorial to explain how investors might use the value premium to evaluate the market:
Value stocks include companies with solid fundamentals that are priced below those of its peers, based on analysis of price/earnings ratio, yield, and other factors.
Growth stocks are those of companies that tend to provide capital appreciation over time rather than current income through reliable dividend payments.
The value premium reflects the return difference between value stocks and growth stocks. The higher the percentage, the greater the possible risk-adjusted return on value stocks. Factor investors believe the value premium is a predictable source of return for investors.
Fluctuations are the norm
Despite a 3.5% historical average, the value premium has varied widely in any given year, sometimes registering extreme positive or negative performances. In fact, the value premium fell within 2% of the historical average in only a handful of years. The rest of the time is was above or below the mean.
Chart 1 below documents the value premium over 10-year annualized performance periods, sorted from highest to lowest. This context shows two important facts about the value premium:
Chart 1: 10-Year Value Premiums in US Markets
1. In most cases, the value premium is positive over a given 10-year period.
2. Our current stretch of extended underperformance–while disappointing–is not unprecedented. In fact, it’s fairly middle-of-the-road.
No one can predict exactly how long the current period of underperformance will last. What we can say is that historical trends show the frequency of a positive value premium increases with the time horizon.
Chart 2 shows the percentage of time that the value premium was positive over different time periods dating back to 1926. The chance of a positive value premium increased with the length of time measured. For example, when the measured time period jumps from five years to 10 years, the frequency of a positive average premium increase from 75% to 84%.
Chart 2: Historical Performance of Premiums over Rolling Periods, July 1926–December 2017
Uncertainty is a Certainty; Patience is a Virtue
What does all this mean for investors?
- While a positive value premium is never guaranteed, history shows the premium has a greater chance of being positive the longer the time horizon observed.
- Even with long-term positive results, periods of extended underperformance can happen from time to time.
- The value premium has not historically materialized in a steady or predictable fashion. For that reason, a consistent investment approach that maintains an emphasis on value stocks in all market environments may allow investors to more reliably capture the premium over the long run.
Should you take the value premium into account when building a profitable portfolio? FJY Financial can help you chart the best investment strategy to achieve your unique investment goals.
Source: Dimensional Fund Advisors LP.