Small Value Stocks are Cheap

Historically, small value stocks have been the best performing equity asset class. But the last 10 years has been a period of dismal performance. With their valuations now at a historically attractive level, small-value stocks are priced to outperform.

From 1927 through June 2019, the Fama-French (FF) US Small Value Research Index returned 14.5% per annum, outperforming the S&P 500 Index by 4.3% per annum. (All FF data is from Ken French’s data library.) In addition, the asset class outperformed after the publication of the famous Fama-French paper “The Cross-Section of Expected Stock Returns” in 1992. For example, from inception in April 1993 through June 2019, the first passively managed fund to provide systematic exposure to the asset class, the DFA US Small Value Fund (DFSVX), returned 11.0% per annum (the Fama-French US Small Value Research Index returned 12.4% per annum), outperforming the Vanguard 500 Index Fund (VFINX) return of 9.4% per annum by 1.6 percentage points per annum.

But small value has performed poorly in the decade-plus since 2009.

From January 2009 through June 2019, while the S&P 500 Index returned 14.3% per annum , the FF US Small Value Research Index returned 12.5% per annum, underperforming by 1.8 percentage points per annum. And VFINX returned 14.2% per annum, outperforming the DFSVX return of 12.5 (the same return provided by the Fama-French Small Value Research Index) by 1.7 percentage points per annum. The decade-long underperformance of small value stocks, even though by a relatively small amount, has caused many to question the ongoing existence of the small value premium.

All risky assets experience long periods of underperformance

Before you jump to any conclusions, it’s important to recognize that the premiums to all risky assets are time varying. In fact, the S&P 500 Index has experienced three periods of at least 13 years over which it underperformed riskless one-month Treasury bills (1929-43, 1966-82, and 2000-12). Thus, while the underperformance of small value over the past decade was unexpected, it should not have been be a surprise. If this did not occasionally occur, there would be no risk, and the risk premium would disappear! The three long periods when the equity risk premium was negative (i.e., bonds outperformed stocks) also demonstrates that even 10 years of underperformance of a risky asset class is likely nothing but noise. They also explain why investors demand a large equity risk premium!

Relative valuations

While investments have uncertain performance, valuations do provide information as to future returns: On average, lower valuations have led to higher future returns and vice versa. With that in mind, we can look at the current relative valuations of the various U.S. equity asset classes and see how their recent relative performance has impacted them.