Movement in GameStop’s stock price in 2021 has attracted considerable attention, and deservedly so: It catapulted from $19 at the end of 2020 to a peak of $483 less than a month later. The firm’s market cap briefly surpassed $30 billion. As deserved as the recent attention may be, however, many pundits are overlooking another piece to the story: The stock traded below $3 a share in spring 2020, and its market cap was less than $180 million.
When the stock was bottoming in spring 2020, it was trading at less than one-twentieth of its sales, i.e., two-and-a-half weeks’ worth of sales. It’s easy to become desensitized to extreme ratios when evaluating public equities, particularly when taking a broad view across hundreds of companies. A comparison may highlight just how extreme GameStop’s trough valuation was last year. Who would sell a small business generating $1 million in annual sales for $50,000? A very competitive bidding war would likely ensue if a deli, car wash, gas station, or convenience store was offered for the equivalent of two-and-a-half-weeks of sales. We cite this context to highlight the extreme opportunities available last year when pandemic-induced panic was peaking.
Many companies were left for dead last year. Globally, ample opportunities abounded for investors to buy shares of consumer goods, transportation, and commodities firms at massive discounts. Simultaneously, a narrow subset of high-flying growth companies was experiencing massive price appreciation that drove their shares to dominate traditional market indices. PIMCO’s RAE strategies sought to take advantage of these opportunities, increasing exposure to cheap companies in early 2020 and setting the stage for potential excess returns when mean reversion began.
How did we get here?
Value was in the midst of its longest losing streak on record in late 2019, leading us to begin work on a paper titled “Reports of Value’s Death May Be Greatly Exaggerated”.Footnote1 Value indices – defined using the price-to-book ratio – had lagged their core (broad equity) counterparts in every major region by 1.4 to 2.3 percentage points annually for up to a dozen years.Footnote2 The drawdown for value began in 2011 in emerging markets, but started even earlier in 2007 in the developed markets; see Figure 1.
The remarkable returns for mega-cap growth stocks drove the vast majority of value’s underperformance. By the end of 2019, six companies – Facebook, Amazon, Netflix, Microsoft, Apple, and Google – accounted for more than 15% of the S&P 500 Index. The combined market capitalization of these six firms exceeded the aggregate price of the publicly listed companies in every country except the United States and China, according to FactSet. These six companies were worth more than the entirety of the Japanese market and more than the combined value of the publicly listed companies of any three countries in Europe. This spectacular surge in technology-related companies in the S&P 500 came at the expense of value sectors, such as energy, which saw its weight drop to little more than 4% of the S&P 500 at the end of 2019.
In emerging markets (EM), where the combined weight of Alibaba and Tencent stocks accounted for more than 10% of the MSCI EM Index, the concentration in market capitalization was even more pronounced than in the U.S. As these stocks soared coming into 2020, value sectors in the emerging markets also fell on the other side of the trade. Energy’s share of the MSCI EM Index shrank below 9%, less than half the sector’s 20% weight in 2011 at the beginning of the EM value drawdown.
How did value stocks’ performance affect valuations?
By definition, value stocks are always cheaper than growth stocks, but the degree to which value is cheaper varies over time. Value’s discount to growth can narrow (getting more expensive) and it can widen (getting cheaper). The recent decade-long period of underperformance led to large discounts for value stocks.
At Research Affiliates, our long-term preference has been to use several valuation measures, because no single metric is perfect. Instead of relying on a single ratio, we calculate an aggregate discount across five ratios: price to earnings, price to sales, price to book value, price to cash flow, and price to dividends. Each is measured relative to the same measure for the market as a whole. Based on all five ratios, value was trading at an above-average discount in every major region at the end of the third quarter 2019 (see Figure 2). Then these large discounts deepened further in every region as value massively underperformed broader stock markets across the globe over the following year. Only in developed international markets did value manage to stay within 10 percentage points of growth’s return during the same period.
The economic dislocations, brought on by the stay-at-home orders intended to slow the spread of COVID-19, hit value companies particularly hard. Brick-and-mortar retailers saw customer traffic disappear, transport-related companies moved far fewer people and goods, and some commodities-related firms experienced a precipitous drop in demand. The struggles of value stocks we had noted in September 2019 only worsened as value underperformed by more than 12% in every major region over the following 12 months.
What did RAE do in this environment?
Following the extended underperformance of value, each of the PIMCO RAE Funds ended September 2019 at a valuation lower than its average relative to both value and core indices. The Funds’ discounts only grew further over the following 12 months, in lockstep with the deepening discounts for value companies. As the spread between value and growth deepened, so too did RAE’s value tilt – see Figure 4. This dynamic exposure to value is an intentional and inherent component of the PIMCO RAE Funds’ model-driven process. Sizing positions based on underlying company fundamentals rather than on market prices means that the wider the dispersion in valuation multiples between what we deem to be expensive and cheap stocks, the deeper the RAE value tilt becomes. When stocks become cheap relative to their fundamentals, the PIMCO RAE Funds tend to buy those stocks that are out of favor and avoid those stocks that are in favor and thus expensive.
However, the larger-than-average value tilt does not tell the whole story of the PIMCO RAE Funds’ relative performance. Across developed markets, the PIMCO RAE Funds outperformed value indices when value trailed broad markets in the 12 months ending September 2020 and again when value then rotated into favor over the months that followed – see Figure 5.
Broadly speaking, we see two important elements of the RAE methodology that generally enabled it to outperform value stock markets both when value was losing and when value was winning.
Given the dynamic nature of the RAE value tilt, which correlates with the magnitude of value’s cheapness, the RAE portfolios did not reach peak value exposure until value reached its own peak discount. Additionally, the momentum and quality components of the RAE process enabled the strategy to avoid some of the stocks that experienced the most significant drawdowns when value was under pressure. For example, the momentum of U.S. energy companies’ share prices was poor in early 2020. The negative momentum was due in no small part to the price of oil dropping precipitously – briefly even reaching into negative territory on the front-month contract – when transportation-driven demand dried up. The PIMCO RAE US Fund waited to rebalance into U.S. energy companies until their strongly negative momentum began to abate.
The quality and momentum components of the RAE approach helped the Funds perform better (i.e., lose less) than value in the developed markets during the 12 months of value’s severe underperformance that ended in the third quarter of 2020. The strategy’s value tilt, however, which had become strongly pronounced because of the wide valuation gap between value and growth, led to the strategy’s outperformance as value rotated into favor.
After value’s rebound began in late 2020, the PIMCO RAE Funds subsequently outpaced not only broad markets but also value indices in every region. RAE’s dynamic value orientation led to significant outperformance during the nine months ending June 2021. Each of the four Funds beat their secondary (core) benchmarks by 11 to 36 percentage points as the cheap companies favored by the RAE strategy rallied and the mega-cap growth companies that had come to dominate the market cooled modestly. Over the same time frame, the RAE Funds also led their primary (value) benchmarks by 4 to 22 percentage points as the strategy reaped the benefits of reaching a deeper value tilt than the value benchmarks themselves (see Figure 5).
Perhaps the most interesting result of all is that the RAE strategy beat value on the way down, and again during its recovery, in U.S. large and small companies and in international markets. Consider a typical value cycle: Value wins, then loses, then wins, then loses. By reducing the value tilt after value wins and increasing it after value loses, we can potentially turn the saw-toothed pattern of the value cycle into a “ratcheting effect.” We have observed this pattern over several market cycles and in several geographies. What changed in this instance was merely the magnitude of the opportunity for contrarian trading. In all four of the regions noted above, the value indices we have referenced simultaneously underperformed their growth counterparts by more than 25 percentage points over the 12 months ending September 2020. During the life of the PIMCO RAE funds, none of these four value indices had ever trailed their respective growth counterpart by that amount individually, much less at the same time.
What about emerging markets?
The RAE performance pattern in emerging markets is a notable outlier. We believe the difference in the performance experience in emerging markets was driven largely by the country neutrality that MSCI applies when rebalancing its multi-country style indices, including the MSCI EM Value Index (RAE EM’s benchmark). Country neutrality to a parent core index does not always make a significant impact on the performance and characteristics of value indices, but when one or several countries become extremely expensive and therefore a large weight in the broad market, forced country neutrality at the time of rebalance can lead to some counterintuitive positioning in the style indices.
After years of strong performance by expensive (highly valued) internet companies, notably Tencent and Alibaba, Chinese equities became a 40% weight in the MSCI EM Index in 2020. “Country neutrality” means the value style index is required to match that large country weight at the time of rebalance. At their price peaks in 2020, Tencent and Alibaba alone represented more than 15% of the MSCI EM Index. Given their valuations, neither Tencent nor Alibaba qualified for the value index. The result was that the bar in terms of valuation for Chinese firms’ inclusion in the MSCI EM Value Index was considerably lower than that required of firms located in other countries. Reciprocally, the hurdle for including Russian or Brazilian firms, for example, was quite high. Each country represented less than 10% of the value index despite the presence of a number of large value companies based in each country. This country neutrality created a counterintuitive result. Relatively expensive Chinese stocks qualified for the MSCI EM Value Index, while relatively cheap stocks from countries such as Russia and Brazil were excluded.
As a result, when value was losing in the first three quarters of 2020, the PIMCO RAE Emerging Markets Fund underperformed in the emerging markets while it outperformed in developed markets. This performance dispersion was not due to a difference in the construction of the Funds in developed and emerging markets, but due to the cap-weighted value index in emerging markets being an outlier itself. Given its large exposure to the expensive Chinese equity market, the MSCI EM Value Index did not represent the value exposure that many investors might have expected.
The PIMCO RAE Emerging Markets Fund valuation discount relative to the MSCI EM Value Index supports the notion that the latter isn’t currently providing much value exposure. In August 2020, the Fund had a much deeper discount to core indices in emerging markets than it had in developed markets when China was near its peak exposure in the MSCI EM Index. In addition, the 34% discount of the Fund relative to the MSCI EM Value Index on 30 September 2020 was nearly double the next steepest discount of 18% PIMCO RAE US Fund had relative to the Russell 1000 Value Index.
How are value stocks and the PIMCO RAE Funds positioned going forward?
Value reached a steep discount to the market in 2019. Tumult ensued. The economic slowdown induced by the onset of COVID caused value to underperform massively around the globe during the first three quarters of 2020, but a light at the end of the tunnel in the form of multiple vaccines and reopening economies led investors to reassess the bankruptcy risks of value stocks. Consequently, value began to claw its way back over the following months. Interestingly, after all the volatility and path divergence between value and broad markets’ respective performances, value’s discount is not far from where it began when we highlighted the dispersion at the end of the third quarter in 2019.
And how do the PIMCO RAE Funds compare today versus their positioning at the end of the third quarter of 2019? The RAE Funds’ discounts to value indices at the end of Q2 2021 are likewise fairly close to where they began. Value remains cheap globally and priced for future excess return potential, in our view. RAE’s value discount is elevated as a direct result of the elevated valuation dispersion between value and growth, positioning the portfolios to seek to capitalize on any further mean reversion.
How does contrarian rebalancing work?
Few investors transact at the actual observed high and low of any stock. Picking peaks and troughs is challenging at best. Everyone wishes they had bought shares of GameStop when the stock was below $3 a share in 2020 and sold when the stock reached $483 a share in 2021. We certainly recognize our limitations with regard to buying at the absolute trough or selling at the absolute peak of a company’s share price. Fortunately, we don’t need to buy a stock at its absolute low or sell at its absolute high in order to profit from the excess volatility that market inefficiencies can generate.
Although no investor can reliably forecast the path of returns, they can seek to profit from volatility by essentially serving as a market maker. The role of a liquidity-providing market maker can be approximated by a contrarian investor who rebalances regularly, selling a popular asset that is rising in price and buying an unpopular asset that is dropping in price, in pursuit of profits as prices mean revert. The greater the mispricing in the market, the greater the opportunity for rebalancing to generate excess returns, in our view. Previous market dislocations, such as the tech bubble and global financial crisis, offered excellent opportunities for a contrarian approach to achieve higher returns. The wider the starting valuation dispersion between value and growth, the greater the potential for a contrarian strategy to reward patient investors.
Contrarian rebalancing serves as the anchor of the RAE strategies. Weighting positions by non-price measures of size means inherently buying stocks when they are cheap and selling stocks when they are expensive. The strategy repeats the process regularly in an effort to capture the benefits of mean reversion. Of course, not all cheap companies’ share prices experience mean reversion. The RAE strategy does not blindly rebalance into every cheap stock. Its model-driven process includes quality and momentum components explicitly designed to help the strategies avoid most “falling knives” and “value traps.”
GameStop grabbed headlines in 2021, but in 2020 it merely represented one of many opportunities for RAE to add to positions in cheap companies. The PIMCO RAE Funds purchased shares of retailers, airlines, and miners also at low multiples. These purchases were not made because of any special foresight, but because the dispassionate systematic RAE strategies regularly rebalance companies to the size of their economic footprint as measured by their sales, cash flow, dividends, and book value.
It’s unlikely any company RAE purchases in 2021 will appreciate more than a hundredfold in less than a year as GameStop did. It was an extreme and rare outlier. Nevertheless, the PIMCO RAE Funds should benefit if many of the cheap companies they buy in 2021 experience mean reversion in their performance. This patient approach underpins the contrarian and model-driven PIMCO RAE Funds.
For more ways to elevate your equity potential, visit our strategy page: PIMCO RAE Strategies.