Is the growing valuation gap all it seems?

Australia Value Equity strategy

23 July 2018

Is the growing valuation gap all it seems?
Key points
  • By some naïve measures, there is certainly evidence of a growing valuation spread, and greater valuation opportunities. But other quant measures are showing far narrower dispersions.
  • We believe that naïve and quant measures miss a layer of fundamental insight required to truly understand the level of opportunity.

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By some measures, there is certainly evidence of a growing valuation spread – the gap between the cheapest and average-priced stocks in the market. Wide valuation spreads have historically preceded strong alpha for value strategies.

Most traditional Value indices (such as MSCI Value) are predominantly based on relatively naïve measures such as P/E or price to book (P/B). The divergence in P/E across investment styles that we have already mentioned has caused the valuation spread based on this measure to widen significantly.

Dispersions of P/B, another common indicator of valuation opportunity, have also widen notably for the Australian market.

S&P/ASX 200 Constituent Price to Book

Past performance is not a guide to future returns.
Source: Martin Currie Australia, FactSet; as at 30 June 2018.

However, a note of caution: other measures, which use current earnings/cash flow based metrics and rely less on a mean reversion assumption, are still showing far narrower dispersions.

This is well described by the valuation analysis of Empirical Research Partners on the US market which uses cash flow methods. 

This shows a much lower valuation spread, and as such, less value opportunities available in the market than shown by p/e or p/b measures.

US valuation spreads: expected return of the top quintile compared to the average

Past performance is not a guide to future returns.
Source: Empirical Research Partners Analysis, National Bureau of Economic Research; as at 31 May 2018.

While we agree Empirical Research Partners has a comprehensive quantitative valuation model to assess companies in the US and across the globe, we believe both naïve and quant measures miss a layer of fundamental insight required to truly understand the level of opportunity.