Euclidean uses machine learning to find persistent relationships between company fundamentals and investment outcomes. Through this effort, we have become convinced of the merits of maintaining a long-term commitment to buying good companies at low prices. Indeed, there is abundant evidence from a variety of sources indicating that a fruitful, long-term strategy would be to buy companies that were priced very low in relation to their fundamental qualities, such as their earnings or book values. Moreover, our own research suggests that this has particularly been the case for companies that also have a combination of consistent operations, good returns on capital, and balance sheet strength.

However, the discipline of owning inexpensive companies has delivered muted performance during recent years. Indeed, despite some reversion in 2016, the first half of 2017 has extended the longest period of expensive-stock dominance since World War II. In the past, investor enthusiasm for expensive companies generally has proven to be both cyclical and not a fruitful basis for long-term investing. As we review in this letter, after periods when expensive companies led the market, value investors historically have achieved strong returns.

In the pages that follow, we:

1. Revisit perspectives we shared 18 months ago regarding the history of value and growth cycles.

2. Provide simulations of different value factors’ relative merits in evaluating public companies and constructing portfolios of inexpensive stocks.

Update on the Current Growth vs. Value Market Cycle

In this section, we update an analysis that we first shared 18 months ago that reflects one of the most widely researched approaches to value investing, in which a value stock is defined as having high book equity to market equity.

In this analysis, it should be no surprise to see that the first half of 2017 has extended the current period of expensive-stock dominance. Investors have great enthusiasm for fast-growing FANG stocks and heightened awareness of incredible changes they are thrusting upon the distribution, retail, and media industries (among others).

Amid this enthusiasm, it is crucial to remember that in the past, investors have frequently taken even the best ideas to extremes, operating as though no price is too high for innovative companies driving the future. Likewise, investors often have extrapolated that new advances will make currently profitable and established companies irrelevant, as though there is no price low enough to consider owning shares in such legacy companies.

“Among large-cap stocks, the spread between value and growth is now larger than at any point over the past six decades, with one exception—the top of the dot-com bubble.” Barrons, June 28, 2017

Repeatedly, this dynamic has ended with investors reminded that even the best companies can become bad investments when priced too high, and that valuable opportunities to buy cash-generating companies at very low prices often emerge when outside catalysts spark the flames of fear. These reminders – lurking now, and perhaps ready to ambush investors once again – characterize what repeatedly has occurred across market cycles. You can see this in the graph below.