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Extreme value spreads in Asia

Updated: Feb 13, 2023

In any market, at any point in time, there are cheap and expensive stocks. Valuation differences exist due to varying company growth profiles, regulatory risks, debt levels, structural challenges, and a host of other factors.


Value spreads also vary over time. Again, this can be for numerous reasons, including interest rates, the level of risk aversion, and growth assumptions. Historically, this spread has tended to mean revert and hence it is interesting to examine where we’re currently positioned relative to the historical mean.


Currently, the spread between cheap and expensive stocks in Asia is extremely wide. Relatively speaking, cheap stocks are very cheap and expensive stocks are very expensive.


Methodology

First, we need to define the stock universe. We look at the 5 largest markets based on the Fund’s gross exposure: Japan, Hong Kong, Australia, Korea and Taiwan. We have excluded China ‘A’ shares as we have limited exposure to domestic Chinese stocks, and we have excluded Singapore due to limited breadth.


We focus on the most liquid stocks in each market. For Japan, we analyse the top 500 most liquid stocks and for the other markets we analyse the top 250 stocks.


There are myriad ways to measure value spreads.


Our preferred approach is to:

  • Sort the stocks in ascending order based on last reported book yield. This is a relatable value measure which is often used in academic literature (eg the HML factor). We have also looked at other value factors, including earnings yields and dividend yields, and they tell a similar story.

  • Define the “cheap” universe as the top 30% of stocks and the “expensive” universe as the bottom 30% of stocks.

  • Measure the book yield for both stock groups using cap weighting and equal weighting methodologies.

  • Divide the book yield of the cheap universe by the book yield of the expensive universe. We prefer this approach rather than subtracting book yields as it controls for overall market valuation levels. It is also easy to relate to the final number (eg 5 means that expensive stocks are 5 times more expensive than cheap stocks).

  • Control for country exposure by analysing stocks within markets. This provides the most meaningful results given country is the biggest risk factor in Asia and stock valuations vary considerably by country. We then aggregate the data to get a regional measure of value spreads.

This is very similar to the methodology used by AQR when they did an in-depth analysis of value spreads in the United States last year.


All Stocks – Cap Weighted

Using a cap weighting methodology, expensive stocks are 7.7 times more expensive than cheap stocks. This compares to an average of 5.3 times since the year 2000.


Not surprisingly, the ratio between cheap and expensive stocks peaked during the height of the tech bubble in early 2000, exceeding 13 times. Interestingly, the ratio approached this extreme level early this year when it exceeded 10 times. Despite the recent fall, the current ratio between cheap and expensive stocks is more than 1.5 standard deviations above the mean. And if we exclude the extreme value differentials during the peak of the tech bubble, this increases to more than 2.3 standard deviations above the mean.


Value Spread Cap Weighted for All Stocks Feb 2000 to Sep 2021

Source: FactSet, OQFM


Excluding Mega Cap Stocks – Cap Weighted

If we exclude mega cap stocks (defined as the top 5% of stocks in each country), recent value spreads are even more pronounced relative to the tech bubble.


Value Spread Cap Weighted Excluding Mega Caps Feb 2000 to Sep 2021

Source: FactSet, OQFM


Excluding Expensive Stocks – Cap Weighted

If we then exclude the most expensive stocks (defined as the bottom 10% of stocks based on book yield in each market), we get an even better appreciation for just how extreme the current market environment is. The value spread during the tech bubble was driven disproportionately by the excessive valuations of a relatively small number of stocks. When we exclude these stocks from the stock universe, the recent peak in the relative value ratio significantly exceeds the tech bubble level.


Value Spread Cap Weighted Excluding Expensive Stocks Feb 2000 to Sep 2021

Source: FactSet, OQFM


Sector Neutral – Cap Weighted

To get an even better appreciation for how broad-based value spreads are, we sector neutralise the data. We analyse the book yield spreads within sectors using FactSet’s sector classification scheme (comprising 20 sectors). Using this approach, the value spreads during the height of the tech bubble are much closer to historical norms. Recent value spreads, however, are still outliers and, despite the recent decline, the current value spread is still more than 2 standard deviations above the historical mean.


Value Spread Cap Weighted Sector Neutral Feb 2000 to Sep 2021


Source: FactSet, OQFM


Sector Neutral – Equal Weighted

If we equal weight the data (rather than using a cap weighting methodology), the data tell a similar story. Rather than replicate all the charts, we only show the data for the sector neutral value spreads. Once again, the current value spread is more than 2 standard deviations above the historical mean.


Value Spread Equal Weighted Sector Neutral Feb 2000 to Sep 2021

Source: FactSet, OQFM


Are Cheap Stocks Really Cheap or Expensive Stocks Really Expensive?

So far, we’ve determined that, no matter how we slice and dice the data, value spreads in Asia are extremely wide. Next, we determine whether the spread is driven by cheap stocks being really cheap or expensive stocks being really expensive (relatively speaking).


To do this, we calculate the book yield for the cheap and expensive stocks (comprising the top and bottom 30% of stocks ranked by book yield) relative to the book yield of the remaining 40% of stocks. This is done using an equal weighting, sector neutral methodology. We then calculate the difference between these ratios and normalise the data over the sample period. A number above zero indicates that the value difference is disproportionately driven by cheap stocks and a number below zero indicates that the value difference is disproportionately driven by expensive stocks.


The data currently indicate that the value spread is being driven by expensive stocks.


Cheap / Middle minus Expensive / Middle Feb 2000 to Sep 2021

Source: FactSet, OQFM


Summary

Value factors have strong intuitive appeal and strong backtest results in Asia over the long term. Over the last few years, however, value factors have underperformed and the spread between cheap and expensive stocks has increased significantly.


Unlike during the tech bubble, the value spread is broad-based and isn’t driven by a relatively small number of stocks.


Further analysis shows that expensive stocks are particularly expensive compared to cheap stocks.


Given Asian equity markets are close to record highs and equities are richly priced, expensive stocks are at extreme valuation levels. If anything happens to undermine the investment thesis for these stocks, there is considerable downside risk.

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