SUMMER 2006 | 15

VALUE STOCKS HAVE PERFORMED REMARKABLY

well since stock markets peaked in March 2000,
with the Morgan Stanley Capital International
(MSCI) World Value Index returning a cumulative
29.9 percentage points more than the MSCI World
Index through February 2006 (Display 1). But it
doesnt automatically follow that value stocks will
now suffer a large reversal. Indeed, history suggests
they may go on winning, albeit by less than before.
And if a value investor exploits other clues in the
market, apart from classic value measures like low
price/earnings ratios, the odds of success can be
further enhanced.
Few Obvious Mispricings to Exploit
Life is certainly getting harder for the value inves-
tor. Value investing is, of course, all about buying
stocks that are trading below their intrinsic worth
based on realistic estimates of company earning
power. Typically, investors overreact to near-term
problems within a given company or industry and
overly discount the prospects for recovery.
It was easy to fnd undervalued stocks at the peak of
the Internet bubble, when the enormously extended
valuations of high-tech, media, and telecom (TMT)
stocksand the very low prices in much of the rest
of the marketcreated huge opportunities. Today,
price differences between industries are much
smaller, as the new-economy stocks have come
down to earth and other industries have recovered
or fallen by much less. As a result, bargains in the
stock market are harder to fnd.
Our own internal gauge of the value opportunity
in the market at largewhat we call the discount
to fair value, or the amount by which the cheapest
stocks in the global large-cap market are under-
priced compared with the average stockconfrms
this seemingly spartan outlook. Our discount to
fair value measure is currently at the bottom of its
historical range, reinforcing the impression that
there are few pricing discrepancies left to exploit
(Display 2, following page).
When we review past levels of discount to fair
value, we see that extremes in either direction have
tended to be pivotal moments for value investing.
The very small valuation differences that prevailed
in 1997 marked the start of growth stocks unprec-
edented bull run and a very diffcult time for value
investors. At the other extreme, the massive differ-
ences in March 2000 marked the end of growth
stocks outperformance and the tremendous revival
of value stocks.
How to Succeed at Value Investing
By Really, Really Trying
Six years after the bursting of the Internet bubble, some people think that value stocks cant
outperform much longer. But there are ways to keep winning with value stocks even when
theyre not in favor.
Display 1
Has value run its course?
Cumulative Returns (U.S. Dollars)
Mar 2000Feb 2006
MSCI World Value
MSCI World
(Index)
Value Outperformance
29.9%
40
60
80
100
120
140
06 05 04 03 02 01 00
Past performance does not guarantee future results.
Index = 100 as of March 2000
Source: MSCI
16 | BERNSTEIN JOURNAL: PERSPECTIVES ON INVESTING AND WEALTH MANAGEMENT
Small valuation differenceshard times for value;
big differencesgood times. Little wonder, then,
with the valuation gap small again, that value
investors are nervous.
Change in the Wings
To gain insight into what may happen next, we
examined the causes of todays narrow spreads,
compared todays situation with previous simi-
lar periods, and weighed the implications for our
value-based portfolios. We discovered two factors
at play that seem to be causative.
First, investors are far less confdent today about
long-term company earnings than they are about
more immediate earnings, so that theyre unwill-
ing to pay up for expected future earnings. This is
understandable: Earnings growth has been so fast
in recent years that investors are cautious about
expecting more. So the best growth stocks are not
selling at exorbitant valuations.
Second, at this moment no industries or sectors
face problems so huge as to cause stocks in that
industry to become really cheap.
Both these factors were also observable in past
instances of very small valuation spreads. And in
all cases, once they hit an extreme, the differences
in stock valuations increased again. In fact, over the
past 34 years, extremely large and extremely small
stock-valuation differences have tended to move
toward normal within the following two years
(Display 3).
Spreads Reect Real Economic Trends
Evidence is surfacing that the same scenario is
starting to unfold now. One clue is the change in
corporate behavior as refected in capital spending.
Before the Internet bubble, investment in additional
production capacity was about the same in the new-
economy telecom and old-economy paper industries
(Display 4). Both were investing in capacity at
a faster rate than their assets were depreciating.
In other words, they were expanding their abil-
ity to produce, which was not surprising given the
strength of the economy at the time.
But as people became ever-more enthusiastic about
new-economy industries, investment spending in
telecommunications simply soared. Meanwhile, the
rise of information delivery via electronic media like
the Internet, along with general pessimism about
old-economy industries, caused paper companies to
Display 3
The value opportunity is mean reverting
Mean Reversion of Global Discount to Fair Value*
Year 2 Year 1 Year 0
Widest Quintile
25
30
35
40%
Narrowest Quintile
Long-Term Average
* Monthly observations of discount to fair value of stocks in MSCI All Country
World Index from 1971 to March 31, 2005, ranked into quintiles; discount to
fair value of highest to lowest quintile is plotted 12 and 24 months after initial
observation.
Source: MSCI and Bernstein
Display 2
The value opportunity is at an all-time low
Discount to Fair Value
Global Equities
Japan Asset Bubble
Internet Euphoria
Oil Shock
10
20
30
40
50%
06 03 99 95 91 87 83 79 75 71
Through March 31, 2006
These data represent the amount by which the most attractively priced large-cap
stocks within each market sell below overall market valuations. The proportion
of Bernstein investments in stocks from this group will vary over time but will
typically be high. Bernsteins estimates of the fair value of these stocks may not
be realized for a variety of reasons.
Source: Compustat, Datastream, DRI, FactSet, MSCI, and Bernstein
SUMMER 2006 | 17
cut back on expansion. And so, at the peak of the
Internet bubble in early 2000, investments in new
capacity in telecom and paper were miles apart.
As we now know, the level of capital spending in
telecom turned out to be excessive. It fell dramati-
cally when the Internet bubble burst and whatever
cash still existed at telecom companies was needed
to repay debt and rebuild balance sheets. Capital
spending in telecom and paper thus gradually
converged. And just as telecom stocks had become
much more expensive than paper stocks during the
expansion period, now the valuations of the two
industries similarly converged.
The lesson is that large differences in stock valu-
ations hold the seeds of their own demise. But
interestingly, this doesnt seem to happen to the
same extent at the other end of the spectrum
when stock-valuation differences are extremely
small. At such times the economy is generally
placid; nothing big is going on. Its possible that
something could happen to cause valuations to
radically diverge, like a sudden slowdown in GDP
growth, or a bout of irrational investor exuberance
over a particular sector. But neither scenario seems
likely at the moment.
Todays Low-Risk Environment Is Deceptive
Given all this, what should value investors be doing
in the current small-spread environment? One
widely touted view argues that when you fnd an
especially undervalued stock you should load up on
it. Yes, spreads will probably widen before they fall
again, but these investors think the risk is smaller
than the opportunity.
Were not so sure about that. In fact, our analysis
suggests that risk for value stocks as a group is
starting to increase. The hard fact is that theres
simply not as much extra return potential in classic
value stocks at the moment as usual. As a result,
very large investments in any particular value
stock, or group of value stocks, are not warranted.
To the contrary, our Strategic Value accounts are
more broadly diversifed at the moment than usual.
But rest assured that when stock mispricings pick
up again, well take on enough risk to be able to try
to capture the returns those opportunities should
provide, focusing on the industries that hold the
most promise.
Exploiting a Diverse Tool-Set
Does this mean weve given up on outperform-
ing the market for the time being? Absolutely not.
For one thing, our intense company and industry
research is still enabling us to uncover instances
where price/earnings, price/book value, and price/
cash earnings ratios are notably below average. And
were going beyond classic value measures in this
environment, paying special attention to factors like
stock-price momentum and company proftability.
Our research has found that when coupled with low
stock prices, these additional measures can further
pinpoint stocks with the high potential to outper-
form. Other factors like exchange-rate movements,
interest rates, and balance-sheet accruals also color
our view of a stocks attractiveness more than usual
in this environment. When all these signs point in
the right direction, an active value-based manager
Display 4
Wide value spreads are self-correcting
00 99 98 97 01 02
Widening Spreads Narrowing Spreads
03
50
100
150
200%
Paper
Telecom
Capital Spending
Just Equals Depreciation
04
Capital Spending vs. Depreciation
Based on U.S. company data
Source: Citigroup, MSCI, Worldscope, and Bernstein
18 | BERNSTEIN JOURNAL: PERSPECTIVES ON INVESTING AND WEALTH MANAGEMENT
can earn substantial extra return even in a low-
spread environment (Display 5). Although the stars
wont always align perfectly, a focus on all of these
factors can really help identify winning stocks.
The upshot is that history provides several useful
lessons for today. It tells us that value investing
can succeed even when valuation spreads are very
small, if not on the grand scale possible in more
unsettled markets. And that success can be magni-
fed by capitalizing on clues other than the classic
value measuresclues we call value-plus factors,
which, when combined with a low stock price, can
help tilt a value managers odds of winning in a
favorable direction. n
Display 5
The value-plus approach
Value Factors
Company
Success Factors
Other Factors
Return on
Equity
Stock Price
Momentum
Interest Rates
Balance-Sheet Accruals
Currency Momentum
Purchasing-Power
Parity
Price/Earnings
Price/Book
Price/Cash
Earnings
Source: Bernstein