This is What Cheap Stocks Look Like in 2020
Jonas Elmerraji, CMT
Last week, we took a look at the extreme spreads between the most expensive stocks and the cheapest stocks in the market today.
Turns out, at the same time the market feels extremely frothy by most measures, the cheapest cohort of stocks is really cheap. That’s a big deal since the last time this group's price-to-cash flow multiple dipped below 3x, it paid investors 23% annualized returns for the next five years.
Since then, a couple of people have asked me about this “bargain bin” group – what does a cheap stock actually look like right now?
And are they cheap for a reason?
So, today, I wanted to dig a little into what this group looks like, warts and all.
First, a little context on what I mean when I say “value”. We’re talking about the value factor – as in quantitative value, not single-stock-pick-value.
Think Fama & French, not Graham & Dodd.
For that reason, I'm trying to avoid single names. It’s important to look at these stocks as a unit. Using it as a universe to pick your favorite one or two value stocks from kind of defeats the purpose.
Also, we're looking at P/CF here to stay consistent with last week’s data, but pick your value factor poison (or better yet, value factor ensemble) -- they're all generally doing the same thing right now.
There are a couple of unsurprising takeaways here, and some are more surprising. Here’s the rundown…
First, these are the sectors that are most heavily represented in the cheapest decile of value:
1. Energy and Financials are Cheap
No surprise, sectors like Energy and Financials make up the biggest chunk of deep value right now.
But the names in the group aren’t exactly distressed. Some of the biggest include Morgan Stanley (MS) -Get Report, Capital One Financial (COF) -Get Report, CNX Resources (CNX) -Get Report, and Hess Midstream (HESM) -Get Report.
But beyond that, there’s a pretty even distribution across the rest of the sectors that’s fairly consistent with the S&P 500 (^GSPC) -:
Only Real Estate has no representation in the deep value group.
2. Cheap Stocks Haven’t Changed Much
Surprisingly – to me anyway -- the stocks that represent the cheapest decile of the market haven’t changed much since the end of 2019, before the COVID-19 crash sent stocks plunging. The cheap got cheaper, but generally speaking the recent volatility spike hasn’t changed which names are represented.
3. Cheap Stocks Come in All Sizes… But Mostly Small
Another non-surprise – cheap stocks skew smaller. That’s exacerbated now by the fact that the biggest stocks on the market are outperforming by a ton in 2020. So, the outliers for the broad market are huge and they’re expensive.
One result of that is very high correlation between the value and size factors in 2020. Again, not a huge surprise – historically size has the strongest correlation with value, we’re just seeing it surge this year.
That said, there’s plenty of large and mega-cap representation on the list.
Finally, a quick note on whether cheap stocks are cheap for a reason right now…
Yes, of course.
There’s always a “reason” why the bottom decile of value is where it is. And there’s always financial distress in this cohort. But that’s maybe missing the point.
The data show that owning this group (and thus avoiding the idiosyncratic risk of trying to pick your favorite value name) systematically outperforms in the long run.
At current levels, we’re talking 23% annualized returns for the next five years.
There’s cheap and then there’s cheap. And right now, the data suggest that it may pay to be contrarian in some of the most-hated sectors.