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Spread's The Word: Valuation Differentials Present Opportunity


The cheapest stocks in the market are "very cheap" based on a valuation spread analysis.

Typically when valuation spreads are this wide, there are strong returns for value stocks looking 3 & 5 years out.

We've identified five value stocks that score highly according to our Piotroski, Graham and other value models.

As the buzz of conjecture continues around the expensive market and how this extended bull must be running out of road, an interesting situation has emerged in the form of expanding valuation spreads when comparing the cheapest stocks in the market to the market itself. The chart below, courtesy of Pzena Investment Management (full report here), shows the spread between the cheapest stocks in the market, ranked book-to-price, relative to an equally weighted market portfolio using book-to-price.

Source: Sanford C. Bernstein & Co.; Pzena analysis. Data as of June 30, 2016

Source: Sanford C. Bernstein & Co.; Pzena analysis. Data as of June 30, 2016

The large spike in the late 90s and early 2000s represents the dot com bubble, where high valuation growth names dominated value stocks, but as you can see in the last few years, a significant valuation spread has emerged and the current spread is well over one standard deviation, which historically has represented an opportunity for value stocks and value oriented investors.

Cause and Opportunity

Investors have been favoring growth stocks, most notably the "FANG" shares (Facebook (NASDAQ:FB), Amazon (NASDAQ:AMZN), Netflix (NASDAQ:NFLX) and Google (NASDAQ:GOOG) (GOOG.L)) which, in 2015, gained $450 billion of market capitalization (a 61% increase) while their combined earnings rose by only 21%. At the same time, value-oriented stocks (especially in the energy and financial sectors) have weakened considerably. The Pznea report also points out the difference between the cheapest stocks and the most expensive stocks by looking at the spread between the Q1 and Q5 quintiles. As of the end of the second quarter the most expansive stocks (which include growth stocks and also the extended defensive areas of the market) are now over four standard deviations above the norm and only in the late 90s was the spread between the cheapest and most expensive stocks higher.

While cheap stocks tend to be cheap for a reason, there is some debate around whether the reasons are more grounded human psychology or in risk-related factors. Buying "cheap", unloved stocks makes intuitive sense because if a stock trades lower but the...