Third Quarter 2017 Newsletter Commentary

Third Quarter 2017 Newsletter Commentary


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Even at today's valuation of the broad market, value's opportunity set looks attractive, and history is on its side.

Investors are all asking the same questions:

  • Aren't equities [particularly in the U.S.] expensive?
  • What should return expectations be going forward?

Over our 21 years in business, we have never tried to time the market. Rather, we seek to exploit valuation dislocations through fundamental research, confident that superior research and a long-term perspective will generate excess returns across market environments. Despite increased chatter among investors surrounding higher and higher equity valuations, we continue to find what, in our view, are compelling opportunities with the potential for double-digit returns within the cheapest stocks.

First, a look at the broad market. By our calculations, the expected return on the S&P 500 is about 6% today. While this is lower than the 20 year average of closer to 8%, it compares well to the height of the internet bubble in early 2000, where the markets' expected return was more like 4%. At that time, interest rates were closer to 6%, thus creating a negative equity risk premium for the first time since 1980. Today, with U.S. Treasury bonds yielding 2.3%, the incremental advantage of stocks versus bonds is fairly normal (Figure 1).

Figure 1: S&P 500 Expected Return over 10 Year Treasuries Is Normal 1980 – September 2017

One can debate the relative advantages of stocks or bonds, but, for the most part, the debate is unnecessary. Investors do not have to buy the S&P 500. As discussed below, cheap stocks 1 , which we will refer to as value stocks, have offered attractive opportunities throughout history. This is a result of the fact that no matter the market environment, investment controversies exist, providing attractive opportunities for the long-term investor with return potential superior to that of the broad market. Through deep fundamental research, we are able to construct a portfolio of what we view as the most compelling of these opportunities.

Lofty Markets Favor Value

Our internal models suggest that value stocks offer double-digit return opportunities fairly consistently, even during periods of elevated valuations in the broad market. To test this proposition, we examined that forward five-year performance of value stocks from the beginning of market corrections2. Since 1965, there have been thirteen such periods (Figure 2).

Figure 2: Double-Digit Value Stock Returns 1960 – September 2017

Start of Correction Market Corrections Since 1960
Duration [months] Forward 5 Year Performance from Beginning of Correction
Value Stocks Top 500 U.S. Stocks
2/1/1966 8 9.5% 3.7%
12/1/1968 19 -1.1% 0.9%
1/1/1973 21 12.8% -1.0%
7/1/1975 3 17.4% 9.0%
3/1/1980 1 26.3% 14.0%
12/1/1980 20 25.7% 11.6%
9/1/1987 3 10.6% 8.3%
6/1/1990 5 17.3% 11.3%
7/1/1998 2 0.5% -2.1%
4/1/2000 30 10.2% -4.1%
11/1/2007 16 -3.8% -0.1%
5/1/2010 2 10.7% 13.5%
5/1/2011 5 5.6% 9.7%
Average Across All Corrections 10.4 10.8% 5.8%

Source: Sanford C. Bernstein & Co., Pzena analysis.

The results are consistent with our return expectations. On average, value stocks returned 10.8% annualized over five years from those market peaks. Even in the wake of the financial crises of 2007 and 2010/11, periods when value generally struggled, value stocks returned 4.2% per annum on average over the ensuing five years.

Our analysis gives us reason to believe that the odds are on the investors' side for value's ability to generate attractive returns going forward. We would not attempt to predict the timing of either market corrections or recoveries, but rather we do know that it is easy to miss meaningful upside from owning value stocks if they are avoided because of fears of a possible market correction. Put another way, for the long-term investor, we believe trying to time the market is an unproductive endeavor.


In today's environment, we believe the return potential of value stocks continues to be substantial. Wide valuation spreads and generally strengthening fundamentals support the opportunity for value performance, and we believe even in the event of a downturn, value stocks offer a compelling opportunity for the long-term investor.

1. Cheap stocks, also referred to as value stocks for purposes of this article, are defined as the cheapest quintile on a price-to-book basis of the largest 500 U.S. listed companies.
2. Market corrections are defined as a 10% decline in the universe of the largest 500 U.S. listed companies.


Past performance is no guarantee of future results. The historical returns of the specific portfolio securities mentioned in this commentary are not necessarily indicative of their future performance or the performance of any of our current or future investment strategies. The investment return and principal value of an investment will fluctuate over time.

The specific portfolio securities discussed in this commentary were selected for inclusion based on their ability to help you understand our investment process. They do not represent all of the securities purchased, sold or recommended for our client accounts during any particular period, and it should not be assumed that investments in such securities were, or will be, profitable.