Large Cap Value Spreads: Making Money from Measly Spreads

Introduction
Cheapest vs. Most Expensive Deciles
Fundamental Consternation & Consideration
Using our Core Products to Expand the Opportunity Set
Summary Tables
Conclusions
Exhibits

Note to readers: This paper is meant for limited distribution. It follows the same format and has many of the same or similar conclusions as does our companion paper, Comparing the Small & Mid Cap Valuation Tails. We apologize for any overlap or sense of repetition caused by the similar nature of both papers.

Introduction

In our first paper published today, Bubble Trouble? Comparing the Current Market to 1999 and 2007, we compared the current situation for our Small & Mid Cap (SMID) and Large Cap universes to the situations during the Tech Bubble and 2007. We showed that Large Cap valuations are at highs second only to the Tech Bubble in 1999-2000 and eclipsing the valuations during 2007. Large Cap ROEs are currently between the record high levels in 2007 and the low levels during the Tech Bubble and are enjoying near record margins now. The brilliance on offer in books like Margin of Safety have been completely forgotten.

Having reviewed the Large Cap market as a whole in our prior piece, we decided to focus our attention on the degree to which value spreads may provide investors with opportunities in stock selection today. We have selected Sales/Price as the metric on which we will decile the stock universes to define “cheap” (i.e., “value”) vs. “expensive” (i.e., “growth”), but the results would be similar had we chosen EBITDA/EV or Book/Price as all three valuation metrics were fairly well correlated in our analyses.

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After doing our analysis for these papers, we were both surprised and disappointed to see such narrow valuation spreads between the most and least expensive stocks. As is often the case when we get into the data, the conclusions are less concise, clean and compelling than we would have liked. In some past periods glamour stocks achieved such high valuation levels despite poor profitability metrics because of investor euphoria surrounding a specific sector (e.g., technology) while ignoring other sectors. This behavior created ripe opportunities for investors via wide value spreads. Unfortunately, as our research will show, both the cheapest and most expensive deciles of firms are similarly expensive relative to their own histories. This spread compression eliminates an “easy” valuation anomaly to exploit, unlike during the 1999 Tech Bubble when spreads were enormous.

The combination of low value dispersion at the tails combined with elevated levels of valuations in both groups implies that investors will have to work harder to find opportunities in a market whose general risk profile seems elevated to us. Our view is that investors who rely heavily on simple metrics of valuation for returns face major headwinds as the margin of safety typically afforded by such approaches may have been eroded by nearly unprecedented levels of price relative to fundamentals. Similarly, our research indicates that investors fond of pursuing the highest growth firms face a universe increasingly characterized by difficult fundamentals, making process around those disciplines more difficult to maintain.

As this paper will show, with value-spreads leaving much to be desired we believe that integrating our Core Model among the least and most expensive firms in the Large Cap space offers investors a powerful tool to exploit the fundamental fractures we see in the most expensive firms while improving the odds of better identifying inexpensive firms whose economic franchises may prove more resilient than their valuation implies.

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Disclaimer

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