By Daniel Campbell, CFA

Historically bad to historically good

Value investors who chose to stay the course through the last few years were finally rewarded for their discipline!

Although it’s hard to believe, if we back up just a few months, the one-year period ending September 2020 was the worst return ever for small value stocks relative to larger, more growthy companies, with small value underperforming by a whopping 52%. The three-year returns were also abysmal, with small value underperforming large growth by nearly 26% per year, which is close to the performance disparity we saw during the tech bubble in the late 1990s. However, with the benefit of hindsight, we now know that September 2020 was the low point, as value stocks roared back to earn nearly 50% more than large growth stocks over the next two quarters.1

Premiums show up in waves

Despite clocking in at an annual average of 4% per year since 1927, the value premium is not earned steadily.2 Rather, it comes in quick waves. The last few years have reminded us that trying to time the market, or even the value premium, can be detrimental to a portfolio’s overall growth. Looking at returns since 1972, Graph 1 shows that a dollar hypothetically invested in small value stocks would have grown to over $400 compared to just $173 for the same dollar invested the total U.S. stock market, a healthy premium of almost $240. But by missing just the five best months for small value stocks during that period, your hypothetical dollar would have only grown to $160, falling short of growth in the total stock market. That’s why the best way to capture the value premium is to stay invested consistently – even through the inevitable underperformance.

Hypothetical Growth of $1 Since January 1972
Impact of Missing Best Months for Small Value

Missing just a few of small value’s best months relative to the total stock market can drastically impact a portfolio’s growth.

Relative earnings show potential for more outperformance

Despite their exceptional performance recently, we know that prices continue to be depressed for small value stocks relative to history. One way to gauge whether stocks are expensive or cheap is to look at the difference in price-to-earnings ratio between small value companies and large growth companies. Historically, a dollar of earnings from large growth companies has cost roughly twice as much as a dollar of earnings from a small value company.3 However, we can see in Graph 2 that earnings from large growth companies have become more than 3.5 times as expensive as earnings from small value companies. From this perspective, small value companies have yet to recover to where they were in late 2017, when the drastic underperformance started.

Relative Price of Earnings in the U.S.



Using the aggregate price-to-earnings ratio, we see the cost of earnings for small value stocks relative to the cost of earnings for large growth stocks has yet to recover to the 2017 levels.

No one can reliably predict what markets will do next. And many factors could cause small, distressed companies to fall in price again. But with valuations at historically high spreads, we can be optimistic about seeing favorable performance from small value stocks that allows disciplined investors to continue reaping the rewards of their patience.