Throughout our history, we've consistently studied the phenomenon of valuation spreads, which measure the valuation difference between the cheapest stocks and the market overall. Our research suggests that when spreads widen significantly, the excess return potential for value investors is significant.
The valuation spreads between the cheapest stocks and the market are now approaching levels last seen during the tech bubble of the late 1990s and are among the widest spreads seen in the past 50 years. Investors are currently awarding premium valuations to high-growth biotechnology and information technology companies, as well as to stocks in the healthcare and consumer staples sectors—areas more associated with stability of earnings than with growth. In the uncertain macro environment that's prevailed since the 2008 global financial crisis, bond proxies such as real estate investment trusts (REITs) and utilities have essentially become momentum stocks.
The historical context of widening spreads
The history of modern valuation spreads is dominated by the 1998/1999 spike, which was instigated by the dot-com era. However, other periods of wide spreads are visible as well, such as the Nifty Fifty era of the early 1970s, in which Polaroid traded at a 400x price-to-earnings multiple; the onset of the 1980s' recession; and the commercial real estate crisis of the early 1990s. Periods of wide spreads represent times in which investors focus on a single factor, shunning one set of stocks in favor of another. The most extreme example of this was the 1998/1999 period, where investors came to believe that old economy stocks tied to the negative events of the Asian currency crisis were to be sold in favor of the limitless possibilities available in the dot-com boom. Valuation spreads grew to be the widest in history, and an investment in stocks at that time implied a theoretical upside of more than 150% as spreads expanded to a level more than four standard deviations above their long-term average.
Since 1964, out of 14 such periods around the globe when valuations spreads widened to greater than one standard deviation above the mean, 13 of the occurrences led to significant value outperformance over subsequent three- and five-year periods.2 Although we believe investors willing to be patient for three to five years are likely to be rewarded, history isn't without its painful exceptions. In October of 2008, spreads in Europe crossed one standard deviation, but subsequent three- and five-year relative performance was poor. In addition, post-2011 performance for stocks with low price-to-book value has been similarly disappointing in the United States, and the five-year record is likely to be negative.
Today's unloved are attractively valued
Economically cyclical stocks have taken it on the chin recently, and financial stocks have probably taken the brunt of the beating, as they trade at significant discounts to their book values. Banks have rebuilt their balance sheets with high levels of capital and liquidity, but conditions in financial markets haven't been conducive to restoring profitability to pre-crisis levels. Prior to the financial crisis, returns on equity (ROE) were elevated at 20% compared with long-term norms of 13%. Currently, global banks generate an average ROE of 7% but trade at a significant discount to book value, which we believe implies a meaningful upside potential.
Lost in all the global volatility was the good news that all of the larger U.S. banks passed the Dodd-Frank stress tests, were largely in compliance with 2019 Basel III capital requirements, and significantly increased their capital return plans. The fact that dividends and share buybacks can now be raised is, in our view, a significant step toward unlocking some of the value embedded in the financials sector.
Our research team has also found opportunities across other areas, including energy and information technology. Our view is that news and sentiment—more than earnings—have been driving stock prices in recent years and that investors in these currently unloved sectors may be rewarded for their patience.
1 Represented by the Russell 1000 Index, which tracks the 1,000 largest stocks in the United States. It is not possible to invest directly in an index. The chart shows three horizontal lines representing the long-term mean and the ± standard deviation, which is a statistical measure of the historic volatility of a portfolio. It measures the fluctuation of a fund's periodic returns from the mean or average. The larger the deviation, the larger the standard deviation and the higher the risk. 2 Sanford C. Bernstein & Co., Pzena Investment Management analysis, 12/31/64 to 6/30/16.
Price-to-book and price-to-earnings ratios are valuation metrics measuring a stock's price relative to its book value and annual earnings per share, respectively.