The current debate about the continued existence of the value premium bears a close resemblance to historical discussions about the equity premium itself, which has been declared dead several times over the years. For example, in 1979, BusinessWeek magazine referred to ‘the death of equities’ as stocks had not earned a premium for over ten years.1
The negative return from equities in the 1970s was explained by high inflation at the time. Companies were not able to grow their net real earnings because of rising costs. This narrative is a useful explanation for disappointing past performance, but is of little use in predicting returns. After that 1979 article, one of the strongest ever bull markets in equities took place.
This shows that the talk about the demise of the equity premium had been highly premature. The bull market ended when the tech bubble burst in 2000, and in 2009, some investors were once again questioning whether the equity premium was dead after another decade of poor returns. Of course, we all know how the 2010s worked out for the stock markets.
One important takeaway from all this is that investors wishing to maximize their chance of successfully harvesting the equity premium need to adopt a long-term horizon and keep a strong hand. If they had gotten nervous and sold when things looked their worst, they could have missed out on huge subsequent returns.
Investors need to think in decades, not in quarters, because stock market returns can swing wildly over short timeframes. This also applies for time-tested factors such as value. For one, our research shows that value returns coming from multiple expansions tend to mean-revert over longer periods of time.
More specifically, when considering holding periods of ten years, we find that value generally becomes cheaper, with multiples expanding, when past returns for value stocks have been low and growth returns have been high. However, we also find that, over the subsequent ten years, value returns tend to be significantly higher than the previous ten years.
From this perspective, current multiples suggest that, over the next ten years, the value premium will probably be substantially higher than its long-term average.
Another important result from our study of long-term investment results is that combining different factors is a good way of reducing a portfolio’s volatility and the probability of prolonged periods of underperformance. Even if value carried no premium at all, it would still help reduce the risk in a multi-factor strategy.
Finally, one last consideration is that while investors are often lured into equity styles, based on their past performance, they actually need strong hands in periods of poor performance to bridge the gap between investment return and investor return. This is because poor timing skills or ‘weak hands’ often cancel out the benefits of being exposed to well-rewarded premiums.
Factors carry premiums, but they inevitably involve periods of pain too. Investors need to be careful not to enter or exit at the worst possible moment – for example, by selling equities in 1979. Value rallies tend to be sharp and difficult to predict, so make sure you stay in the game and live through what is undeniably a ‘value winter’.