Fundamentals of RAE: Deep Value, Bubble Stocks, and Market Inefficiency
- Value stocks entered 2020 on a decade-long losing streak relative to broad equity markets. Then the pandemic-induced market plunge hit many value sectors particularly hard, creating opportunities to invest at significant discounts. Later in 2020, as much of the economy subsequently rebounded, so did many value stocks.
- In Research Affiliates’ view, value stocks in general remain cheap globally and appear priced for attractive return potential.
- Managed by Research Affiliates, the PIMCO RAE Funds embed a systematic equity investment strategy that seeks to capitalize on market inefficiencies. When stocks become cheap relative to their fundamentals (according to Research Affiliates’ valuation process), the PIMCO RAE Funds tend to buy those stocks that are out of favor, and avoid those stocks that are in favor and thus expensive. The funds seek to capture the benefits of mean reversion, and the research-based investment process includes components designed to help the strategies mitigate risks.
Movement in GameStop’s stock price in 2021 has attracted considerable attention, and deservedly so: It catapulted from $19 at the end of 2020 to a peak of $483 less than a month later. The firm’s market cap briefly surpassed $30 billion. As deserved as the recent attention may be, however, many pundits are overlooking another piece to the story: The stock traded below $3 a share in spring 2020, and its market cap was less than $180 million.
When the stock was bottoming in spring 2020, it was trading at less than one-twentieth of its sales, i.e., two-and-a-half weeks’ worth of sales. It’s easy to become desensitized to extreme ratios when evaluating public equities, particularly when taking a broad view across hundreds of companies. A comparison may highlight just how extreme GameStop’s trough valuation was last year. Who would sell a small business generating $1 million in annual sales for $50,000? A very competitive bidding war would likely ensue if a deli, car wash, gas station, or convenience store was offered for the equivalent of two-and-a-half-weeks of sales. We cite this context to highlight the extreme opportunities available last year when pandemic-induced panic was peaking.
Many companies were left for dead last year. Globally, ample opportunities abounded for investors to buy shares of consumer goods, transportation, and commodities firms at massive discounts. Simultaneously, a narrow subset of high-flying growth companies was experiencing massive price appreciation that drove their shares to dominate traditional market indices. PIMCO’s RAE strategies sought to take advantage of these opportunities, increasing exposure to cheap companies in early 2020 and setting the stage for potential excess returns when mean reversion began.
How did we get here?
Value was in the midst of its longest losing streak on record in late 2019, leading us to begin work on a paper titled “Reports of Value’s Death May Be Greatly Exaggerated”.1 Value indices – defined using the price-to-book ratio – had lagged their core (broad equity) counterparts in every major region by 1.4 to 2.3 percentage points annually for up to a dozen years.2 The drawdown for value began in 2011 in emerging markets, but started even earlier in 2007 in the developed markets; see Figure 1.
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The remarkable returns for mega-cap growth stocks drove the vast majority of value’s underperformance. By the end of 2019, six companies – Facebook, Amazon, Netflix, Microsoft, Apple, and Google – accounted for more than 15% of the S&P 500 Index. The combined market capitalization of these six firms exceeded the aggregate price of the publicly listed companies in every country except the United States and China, according to FactSet. These six companies were worth more than the entirety of the Japanese market and more than the combined value of the publicly listed companies of any three countries in Europe. This spectacular surge in technology-related companies in the S&P 500 came at the expense of value sectors, such as energy, which saw its weight drop to little more than 4% of the S&P 500 at the end of 2019.
In emerging markets (EM), where the combined weight of Alibaba and Tencent stocks accounted for more than 10% of the MSCI EM Index, the concentration in market capitalization was even more pronounced than in the U.S. As these stocks soared coming into 2020, value sectors in the emerging markets also fell on the other side of the trade. Energy’s share of the MSCI EM Index shrank below 9%, less than half the sector’s 20% weight in 2011 at the beginning of the EM value drawdown.