The value investor has become something of an endangered species over the last decade, pushed to the side-lines of a market fixated on seeking never-ending growth in areas such as technology.
The underperformance of the value investment style has been much discussed, and – barring a relatively short rally this year- mostly painful for deep value investors such as us on the value investment team at Schroders.
The result is a wide chasm in the valuations of the cheapest shares and the most expensive.
This has not gone unnoticed. Indeed, one of our favourite columnists in the FT last week, Robert Armstrong, said “value stocks look like a heck of a value right now!”. He pointed out that the ratio of the price/earnings multiples of growth and value stocks in the US was now at a 20-year low.
This is true and compelling. But there is a place where the differential is even more pronounced: Europe. And what’s most surprising of all, is that – counterintuitively – Europe’s cheapest companies have been delivering higher profit growth than Europe’s most expensive companies.
Here are three charts that tell the story.
The first one looks at the valuation dispersion between growth and value in Europe, using data from Morgan Stanley that combines three valuation measures: price/earnings (P/E), price/book (P/BV) and price/dividend (P/Div).
While the similar value spread in the US is undoubtedly cheap, the data in Europe is eye-wateringly so. Europe has gone lower than the dotcom nadir around the turn of the century and the recent bounce still leaves a very long way to go.
Valuations of value vs growth are still near all-time lows
While this makes the relative case for value in Europe, let’s not forget the absolute one. Taking the MSCI Europe indices as a blunt proxy for European value and growth, we see that the broad MSCI Europe index is trading on 12-month forward P/E ratio of 15.4, MSCI Europe Growth is on 20.1 and MSCI Europe Value is on just 10.8 (according to data from Bloomberg).
A forward P/E ratio is a company’s share price divided by its expected earnings per share over the next 12 months.
Using slightly different data from Eurostoxx, we see value shares in Europe are currently trading on lower PEs than they were five years ago (see below).
It has been a brutal few years for cheap stocks in Europe. There are very few, if any, parts of developed market equities that the market is so pessimistic about that they’ve actually de-rated over the last five years – whether in absolute or relative terms. (A derating is when the P/E ratio of a stock contracts due to a bleak or uncertain outlook).
Just to really put the boot in, the US’ Russell 1000 value index is on a 12-month forward P/E of 16.5, while the equivalent in Europe is on around 11. This enormous differential shows that a cheap stock in the US is held in much higher regard than a cheap stock in Europe; value stocks in Europe are the unloved of the unloved.
The two points above show that there are similar broad themes in the US and Europe, but that they’re more extreme in the latter.
However, the chart below is what makes the first two points seem completely crazy.
It shows the earnings-per-share growth of Eurostoxx value and growth indices.
Over the last five years, Europe’s cheapest companies have actually delivered more profit growth than their growth counterparts. This is a distinctly European phenomenon and isn’t what you see in other developed markets such as the US, where you have actually got some premium profit growth from growth stocks.
Cynics could say that this is down to the effect of starting from a low base, as the chart starts in 2017 just as the mining cycle turned positive. But we’ve ran this over multiple time periods and you get the same result.
It is also worth noting that the favourable earnings profile for value was in place before the Covid-19 pandemic. It’s not all driven by the profit rebound, commodity inflation and interest rate benefits that have boosted value following the pandemic.
So over that five-year period the real growth stocks in Europe, in terms of fundamentals at least, have been the value stocks.
Value shares have outgrown growth
Bring this all together and there’s a compelling reason to believe value in Europe is looking pretty attractive; almost trough absolute valuations, record levels of relative valuation discount to growth and positive relative earnings momentum. This isn’t a widely shared view, however. Indeed, looking at investor flows and allocations, Europe is one of the most overlooked equity markets in the world. Perhaps not for long.