Peculiar Stock Leadership in 2016

The below exploration of market returns in 2016 was written by my colleague Travis Fairchild.

Bank of America started tracking the performance of active managers in 2003, and 2016 has—thus far—been the worst year on record for active managers: only 18% of large cap managers outperforming the Russell 1000 through June 30th.[1]   The Russell 1000 Value has beaten the Russell 1000 Growth, but the companies with the best returns this year have had a peculiar profile. You don’t see many pitch books that say: “we buy stagnating or low growth businesses trading at average prices,” but that is the profile of the stocks which have led the market in 2016. Let’s explore.

Most Value Factors are underperforming Price to Book; Russell’s definition of Value

Below is a chart showing the year-to-date cumulative excess return for various value factors (measured by the performance of the best decile for each factor) versus our equal-weighted U.S. Large Stocks benchmark.[2] Year-to-date all but dividend yield are negative and price to book is beating all other factors.  Any active managers with a focus on cheap valuation (based on something other than dividend yield) is likely seeing that focus detract from performance. It is likely that dividend managers represent a large portion of that 18% of managers that are outperforming.

figure 1 travis

Our preferred definition of value uses a combined measure from price-to-sales, price-to-earnings, free cash flow-to-enterprise value, EBITDA-to-enterprise value, and shareholder yield; the gap between this value composite and Book to Price is 6% year to date.  This is a significant gap and a very uncommon one.

figure 2 travisThe histogram below shows just how uncommon this gap is; in only 6% of all observations on record have we seen a gap this large.[3]  Since 1963 the value composite has outperformed price to book in 57% of 6 month rolling periods and in over 70% of rolling 1 year periods.

figure 3 travis

Low Growth Companies are Driving the Outperformance of Value Indices

Year to date, the Russell 1000 Value is beating the Russell 1000 Growth by a margin of almost 5%.[4]  But as we saw above, most measures of “value” are doing poorly so far this year, so why the large gap between Russell’s value and growth indexes?

The answer lies in how Russell defines value vs. growth. Russell uses a ranking formula which is 50% value (Price to Book) and 50% growth (EPS growth and 5 Year Sales Growth) to decide where each stock falls on the Value/Growth spectrum.  Anything cheap and/or with horrible growth is considered value and anything with great growth and/or that is extremely expensive is considered growth.  This methodology creates a dynamic where a portion of the Russell Value index is actually slightly expensive stocks that have very bad trailing sales growth and expected EPS growth.  Likewise a portion of the growth index will be stocks with below average or negative growth but defined as growth due to their extremely expensive valuations.

In rare occasions these little talked about groups of stocks can drive performance of the style indices, and that is exactly what we are seeing this year in the Russell 1000 Value.  Below is a chart that shows the excess return of value vs growth for each of the factors used in Russell’s methodology.[5]  While we used decile portfolios to highlight different value factors above, we now tailor the analysis to more closely match Russell’s method (which carves the market into thirds). We start with the constituents of the Russell 1000, and calculate the return difference between the top third and bottom third by each factor. For example, the return of +1.3% for the price to book in the chart below is the result of

  1. Ranking the cheapest third of stocks by price-to-book in the Russell 1000 to build our portfolio
  2. Calculating the return (weighted by market capitalization) of that portfolio for the year
  3. Doing the same for the most expensive third
  4. Subtracting one from the other

You can see that while the cheapest third of stocks by price-to-book has outperformed the most expensive third within the Russell 1000, the difference is relatively small. The real story is the outperformance of low growth over high growth. Companies with the worst sales and earnings growth have outperformed those with the best growth by 8-9% so far this year. The gap of value vs growth indices is more a surge in stocks with terrible sales and earnings growth, and less a triumph of traditional cheap over expensive.

Any active manager avoiding companies with dismal growth will avoid the companies driving returns in the benchmark.

figure 4 travis

Top 10 Contributors in Russell 1000 Value are Not Cheap and have Negative Growth

This becomes even more apparent when you look at the profile of the top performers in the Russell 1000 Value index. The ten names below—which were the top contributors to the benchmark return— make up 20% of the benchmark and contributed 3.5% to the benchmark’s return of 6.3%; over half of the year to date return.

For each stock, we show the percentile rank at the start of the year within the Russell 1000 of the Price to Book Ratio, EPS growth, and 5 year sales growth numbers where 1 would be the cheapest/highest growth percent and 100 the most expensive/lowest growth.  Only 3 of the 10 stocks are even in the cheapest 1/3 of U.S. companies by price to book and the average is just under the median.  Further, 9 of the 10 names had negative (i.e. shrinking earnings) to start the year and more than half had shrinking sales numbers.  The average of these 10 names had earnings that shrunk -27.5% over the last year, a reduction in total sales of -8.5% over the last five years, and they were only slightly less expensive than the market median.

Using Russell style benchmarks to build a market narrative makes sense: they are widely followed benchmarks. But so far this year, the returns of value versus growth are misleading. Cheap is not beating expensive, on average, but low growth is crushing strong growth. Over the longer term, the best strategy is to be long cheap stocks—not long low growth businesses. But being long cheap stocks has thus far failed in 2016.

figure 5 travis

[1] Bank of America Merrill Lynch US Equity and Quant Research.  They began tracking performance of active managers in 2003.

[2] Defined as all publicly traded U.S. companies that have market caps greater than average (non-ADRs).

[3] All rolling periods from 1963 to 2015 using all investable U.S. Large Stocks in the COMPUSTAT database.

[4] From 1/1/2016 to 6/30/2016 the Russell 1000 Value returned 6.3% while the Russell 1000 Growth is up 1.35%