Are you a value investor?
Value investing motto is buying what’s undervalue in the market and then make money from it when the price goes up in a long run. As such, stock valuation strategies will have a great impact on investment returns.
Learn Smart Way of Investment Stock Valuation Strategies from Mr. Alex Bryan, CFA, the director of passive fund research with Morningstar.
Valuations aren’t great for timing investments
Stock Valuations are helpful for gauging expected returns, so it wouldn't be wise to completely ignore them. However, valuations don’t appear to be very helpful for tactical adjustments across regions, sectors, and other various factors. Nor is it helpful for timing exposure to credit risk. If valuations are unusually high, future returns will likely be lower than normal, and vice versa.
Valuations are only moderate
predictor of performance
Based on a study, from January 1970 to January 2019, a one-point increase in the MSCI USA Index’s price/earnings (P/E) ratio was associated with a 0.72% decrease in returns over the next year, while lower valuations had the opposite effect. Valuations could explain only a small part of the variation in stock returns over this period – 6% to be exact. So, the market’s current valuation says little about what its return over the next year will likely be.
Case Study #1:
MSCI USA Index
It can take valuations a long time to revert to the mean, so it’s not surprising they appear to have greater explanatory power of returns over longer holding periods – though that power is still low. For example, with a three-year holding period, starting P/E ratios could explain 15% of the variation in the MSCI USA Index’s returns. The explanatory power was slightly higher over a five-year holding period, as shown in Exhibit 1.
So, why aren’t valuations a better predictor of returns?
That's because they aren’t the only variable that matters. Differences in expected growth rates can justify differences in valuations.
As investors’ growth expectations increase, so do current valuations and stock returns. If they are realised, higher valuations don’t necessarily hurt returns going forward. And there are lots of surprises along the way (both good and bad), as business conditions change, that weaken the relationship between valuations and future returns.
It’s also more challenging for value investing to work for tactical adjustments across regions, sectors, and factors than it is for stock selection, because portfolios aren’t static.
So, portfolio valuations are less comparable over time.
Stock valuation strategy
Using P/E ratios is not enough
To test the efficacy of value-driven tactical adjustments, Alex created a strategy that compared the P/E ratios of the MSCI USA and MSCI World ex USA indexes once every three years (as it can take a long time for valuations to rebound). Whichever index had the lower valuation would receive a 60% weighting in the portfolio for the start of the three-year holding period, while the other would receive 40%. He chose to limit these tilts because it is always important to be diversified across both US and foreign stocks, regardless of valuations.
This strategy didn’t help much. From the end of December 1974 to January 2019, it returned 11.15% annualised, while a static 50/50% split between the two indexes would have returned 11.04%. (The MSCI World Index returned 10.74% over this time.) This weak performance likely stems from the tenuous relationship between valuations and future returns.
The results of valuation timing were even worse when applied to sectors and factors, though there is less data here. Certain sectors (and factors) persistently trade at lower valuations than others, so without any adjustments, using valuations to select sectors would lead to long-term sector biases. However, Morningstar research shows that value-driven sector tilts are a form of active risk that historically hasn’t been well-compensated.
To mitigate persistent sector and factor tilts, Alex modified the strategy to measure the attractiveness of each sector and factor index based on how its current P/E compared with its average over the past five years, favouring those trading at the lowest levels relative to their own history.
The sector strategy ranked the 10 sector indexes listed in Exhibit 2 on this metric and selected the three with the lowest values. It assigned an equal weighting to the indexes that made the cut and held them for three years before rebalancing. The factor strategy followed this same approach using the indexes listed in Exhibit 3. However, it selected the two indexes with the lowest valuations relative to their history.
The results for the sector and factor strategies are shown in Exhibits 4 and 5. The performance measurement periods start in November 2004 and December 2003, respectively, and run through January 2019.
In both cases, the results were disappointing. The sector strategy lagged a static equal sector allocation by 1.19 percentage points annually. Similarly, the factor strategy lagged an equal allocation across the factor indexes by 43 basis points annually (though it beats the MSCI USA Index by 18 basis points).
As with the regional indexes, this largely owes to the weak relationship between relative valuations at the portfolio level and returns. However, it’s worth noting the value investment style was out of favour during much of this time.
Valuations are helpful for gauging expected returns, so it isn’t prudent to completely ignore them. If they’re unusually high, future returns will likely be lower than normal, and vice versa.
However, it probably isn’t a good idea to use them to make big tactical adjustments among fund investments. The benefit will likely be modest at best and can easily be outweighed by lost diversification and tax efficiency.
Consider using other methods when you evaluate stocks.
Some popular stock valuation methods that professional analysts use are below.
Take time to learn and see if it helps you to grow your wealth!