Valuation: A Tale of One Metric

If you can only choose one metric to use when making investment allocation decisions, what would it be?

Our answer is valuation. Why?

• Intuition: all else equal, you should prefer to pay less for the earning power of two similar companies.
• Theoretical justification: most fundamental valuation metrics serve as a reliable proxy for a more complete valuation analysis such as a full-blown discounted cash flow model.
• Empirical evidence: valuation has been shown – through countless academic and practitioner studies – to be highly predictive of future stock returns.
• Persistence: we have a high degree of confidence that valuation will continue to serve as a valuable tool for predicting returns; investors will continue to overpay for glamorous, “hot” stocks, and underappreciate the gains to holding a diversified bucket of “cheap” stocks.

Obviously, valuation is not the only variable worth utilizing for portfolio construction, but it does get you surprisingly far in terms of explaining returns on its own. So which valuation metric is “best”: P/B, P/CF, P/E? The short answer is that it doesn’t matter all that much because you often end up with similar results.

That said, how does the US equity landscape look today from a valuation perspective? Since we are only considering one metric, we want to examine it from every possible angle to squeeze as much insight out of it as possible.

After examining a variety of data points, derived from P/B, across the Russell Style Box universe, there are a handful of facts we find noteworthy (see table in appendix for full data overview):

• Currently, small cap value is the cheapest (P/B of 1.16x) and large growth is the most expensive (P/B of 10.98x).
• Small cap value has been the cheapest for most of the past two decades – not surprising since this is almost guaranteed by construction of the indexes. (More on this later)
• Small caps – across all styles – have experienced the most pronounced decrease in valuation over the past year relative to other market cap segments.
• Currently, small value is priced at around 78% of its historical average and large growth is priced at 187% of its historical average.
• Relative to their own history, small cap value stocks are priced extremely cheap (7th percentile) and large growth is price extremely expensive (92nd percentile).

Our primary takeaway: small-cap value is cheap and has been getting cheaper while large growth is expensive and has been getting more expensive.

As mentioned above, it’s not surprising that small value is cheaper than large growth at any point in time: the indexes are literally constructed to make this the case. The more informative observation is to examine how the ratio of relative expensiveness has changed over time. The below chart shows the ratio of the P/B of large growth to the P/B of small value, often termed the value spread.

Value Spread: LCG vs SCV

Clearly the value spread is at extreme levels: currently sitting at the 99th percentile relative to its history. To a certain extent, it is justifiable to pay more for growth stocks than value stocks – as they are expected to grow their earnings more than value stocks in the future – but we believe paying for large growth stocks at these prices would require investors to be quite confident that their earnings will continue to grow at an ever-accelerating pace.

So why, if valuation is such a strong predictor of future returns as we claim, isn’t everyone trimming their exposure to large growth stocks and allocating more to small value? Some of the common reasons we’ve heard from investors and financial media include:

1. The rise of technology: value investing doesn’t work with the rapid growth of intangible assets.
2. Higher interest rates will disproportionately hurt smaller companies compared to larger ones. (Ironically, low interest rates was previously a reason put forth until recently).
3. An increasingly likely economic downturn in the near future will hurt small caps more than large caps.
4. The Mega Cap companies are competitively positioned to capture greater and greater amounts of market share and drive economic growth for the foreseeable future.

Some of the arguments above may in fact have played a role in the under-performance of small cap value over the last decade, but some – such as sensitivity to interest rates and economic downturns – are simply not supported by the data. Regardless of one’s specific belief about any of these arguments, it is hard to make a case that their impact is sufficient to justify a value spread at the 99th percentile. Our view is that small-cap value stocks are priced extremely attractively right now and that it is likely that overweighting small-cap value will generate strong excess returns going forward. Unfortunately, we do not know precisely when the regime shift will occur, but history has shown the spread can revert rapidly and we aim to position our portfolios in a manner to take advantage of the regime shift.

Appendix

IMPORTANT NOTES

This material is for informational purposes and is intended to be used for educational and illustrative purposes only. It is not designed to cover every aspect of the relevant markets and is not intended to be used as a general guide to investing or as a source of any specific investment recommendation. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. This material does not constitute investment advice, nor is it a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional adviser. In preparing this material we have relied upon data supplied to us by third parties. The information has been compiled from sources believed to be reliable, but no representation or warranty, express or implied, is made by Innealta Capital, LLC as to its accuracy, completeness or correctness. Innealta Capital, LLC does not guarantee that the information supplied is accurate, complete, or timely, or make any warranties with regard to the results obtained from its use. Innealta Capital, LLC has no obligations to update any such information.

The information provided herein, including, without limitation, investment strategies, investment restrictions and parameters, allocation methodologies, and investment and other personnel, may be modified, terminated, or supplemented at any time without further notice in a manner which we believe is consistent with its overall investment objective. Charts and graphs included herein are created by Innealta for illustrative purposes only. There are no guarantees that a portfolio will reflect the allocations and exposures presented.

There is no guarantee that any investment process described herein will be successful or profitable. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. Clients and investors may lose all of their investments.

Analytics are presented for informational purposes only and do not constitute an offer or recommendation to buy or sell securities or to engage an investment manager. Market indices included are a general source of information and may not be the designated benchmark to evaluate an investment’s performance. Such benchmarks and market indices are unmanaged, assume reinvestment of income, do not reflect the impact of any trading commissions and costs, management, and incentive fees, and have limitations when used for comparison or other purposes because they, among other reasons, may have a different trading strategy, volatility, credit, or other material characteristics (such as limitations on the number and types of securities or instruments). No representation is made that any benchmark or index is an appropriate measure of comparison. Market Indices included are a general source of information and comparison to an index does not imply that the strategy will be constructed in the same way as the index or achieve returns, volatility, or other results similar to the index. Potential or current investors should not conclude that the strategy will or will not be correlated with any such index (including those purporting to represent the trading strategies to be implemented by such product). Potential or current investors should not consider any comparative index shown in this document to be a performance benchmark for the strategy. The comparison of indices in general, and to individual managed products in particular, are subject to material inherent limitations, and it is not possible to invest directly into an index.

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Index Definitions: The Russell 2000 Value TR Index measures the performance of Russell 2000 companies with lower price-to-book ratios and lower forecasted growth values. The Russell 2000 Growth TR Index measures the performance of the Russell 2000 companies with higher price-to-book ratios and forecasted growth values. The Russell 2000 TR Index measures the performance of the small-cap segment of the US equity universe. It is a subset of the Russell 3000 Index representing approximately 7% of the total market capitalization of that index. The Russell 1000 Value TR Index is composed of large- and mid-capitalization U.S. equities that exhibit value characteristics. The Russell 1000 Growth Index is composed of large- and mid-capitalization U.S. equities that exhibit growth characteristics. The Russell 1000 TR Index measures the performance of the large-cap segment of the US equity universe. It includes approximately 1,000 largest US stocks, representing 93% of investable US equities by market capitalization. The Russell Mid-Cap TR Index measures the performance of the 800 smallest companies in the Russell 1000 Index, which represents approximately 25% of the total market capitalization of the Russell 1000 Index. The Russell Mid-Cap Value TR Index measures the performance of the mid-cap value segment of the US equity universe. It includes those Russell Mid-Cap Index companies with relatively lower price-to-book ratios. The Russell Mid-Cap Growth TR Index measures the performance of the mid-cap value segment of the US equity universe. It includes those Russell Mid-Cap Index companies with relatively lower price-to-book ratios. Total return indexes reinvest dividends.

Category Definitions: Small Cap Value refers to the Russell 2000 Value TR Index. Small Cap Blend refers to the Russell 2000 TR Index. Small Cap Growth refers to the Russell 2000 Growth TR Index. Large Cap Value refers to the Russell 1000 Value TR Index. Large Cap Blend refers to the Russell 1000 TR Index. Large Cap Growth refers to the Russell 1000 Growth Index. Mid Cap Value refers to the Russell Mid-Cap Value Index. Mid Cap Blend refers to the Russell Mid-Cap Index. Mid Cap Growth refers to the Russell Mid-Cap Growth Index.

3415-INN-11/14/2023