There is a growing chasm between the haves and the have-nots of the stock market. The haves are represented by glamorous growth stocks such as the high-tech darlings powering the internet. Value stocks are the have-nots and include most everything else.
The trend toward glamour and away from value, which favoured firms with software-related business, was building before this year’s COVID-19 crash. The renewed viral breakout in the United States isn’t helping matters.
To get a better sense of the current state of the markets I examined big indexes in the U.S. and Canada. The S&P 500 stands in as a proxy for U.S. stocks while the S&P/TSX Composite Index represents Canadian stocks. The stocks in the indexes are measured using three classic ratios that value investors love: price-to-earnings (P/E); price-to-sales (P/S); and price-to-book-value (P/B). The data behind the calculations come from S&P Capital IQ.
In the U.S., half the stocks in the S&P 500 have P/Es north of 22.7 while the other half have lower ratios. Half the stocks have P/S ratios above 2.45 and half have P/B ratios larger than 3.04. (The calculations focus on stocks with positive ratios in each case. For instance, stocks with negative earnings are not included in the P/E calculations.)
In Canada, half the stocks in the S&P/TSX Composite have P/E ratios below 16.7. Half the stocks have P/S ratios lower than 2.14 and half have P/B ratios under 1.62.
The midpoint of the Canadian market is cheaper than that of the U.S. market on all three value measures, but not outrageously so.
Benjamin Graham (who was Warren Buffett’s mentor) recommends sticking to stocks with P/E ratios under 15 and P/B ratios below 1.5 in his book, The Intelligent Investor. Such stocks are plentiful in Canada with 23 per cent of the index passing both tests.
There are notable differences within each market when looking at the value and glamour segments. I’ve somewhat arbitrarily defined value stocks as those with the lowest 20 per cent of positive ratios (or the bottom quintile) while the glamour stocks have the highest 20 per cent of ratios (the top quintile).
In the U.S., value stocks have P/E ratios below 11.9, P/S ratios below 0.87, and P/B ratios below 1.27. Stocks trading at such low ratios would be viewed as potential bargains by value investors and worthy of more detailed study.
In Canada, value starts with P/E ratios below 9.6, P/S ratios below 0.67, and P/B ratios below 0.84. Value is a relative bargain in Canada based on these measures.
The glamour side of the market is expensive in both the U.S. and Canada. Glamour stocks have P/E ratios north of 38.9 in the U.S. and 36.7 in Canada while their P/S ratios are in excess of 5.66 and 5.15, respectively. The countries differ significantly when it comes to P/B ratios, with U.S. glamour trading north of 7.65 times book value and Canadian glamour above 3.24 times.
The accompanying table summaries the figures for both indexes.
The yawning gap between value and glamour is partly the story of different industry groups. For instance, value tends to be concentrated in financial and resources stocks at the moment, which Canada has in abundance. Alas, such stocks were hit hard by the COVID crash. On the other hand, glamour favours tech stocks, which fared relatively well during the pandemic.
Money manager Cliff Asness, a founder of AQR Capital Management, pointed out in a recent article called Is (Systematic) Value Investing Dead? that the spread between value and glamour is near multidecade highs. He thinks value is far from dead and figures the medium-term odds now dramatically favour value stocks.
The AFATMAN stocks (acronym coined by an AQR employee for Alphabet Inc., Facebook Inc., Amazon.com Inc., Tesla Inc., Microsoft Corp., Apple Inc. and Netflix Inc.) are some of today’s darlings. Take Microsoft (MSFT) as an example. The software firm deserves to trade at a premium to the market owing to the quality and nature of its business. But I’ve owned its shares in the past when it was a value stock. Microsoft traded for less than nine times earnings and less than three times sales in 2011. Today it goes for more than 35 times earnings and 11 times sales. The high price makes it hard for the stock to outperform in the coming years.
While glamour stocks have been on a roll, future gains will be handicapped by their unusually high prices. On the other hand, value stocks are cheap. The gap between value and glamour is likely to narrow in the fullness of time.
Norman Rothery, PhD, CFA, is the founder of StingyInvestor.com.
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