When Cheap Stocks Aren’t So Cheap Anymore

Narrow valuation spreads may reduce the payoff from buying cheap stocks, making future earnings growth and business quality more important.

• After the Global Financial Crisis, scarce growth and near-zero interest rates led investors to pay large premiums for companies with strong balance sheets, reliable profitability, and sustainable growth.
• Over the past five years, cheaper stocks have risen in valuation while the premium for quality and growth has declined.
• International valuation spreads are now unusually narrow compared with their historical ranges.
• With less room for multiple expansion, future returns may depend more on earnings growth from companies with durable competitive advantages.
• Over the past 25 years, when valuation spreads were similarly narrow, the MSCI ACWI ex US Quality Index outperformed the broader index over the following two years 77% of the time, by an average of 260 basis points annually.

Takeaway: Investors may need to place greater emphasis on durable competitive advantages and compounding earnings rather than relying on a rebound in cheap-stock valuations, although the historical relationship does not guarantee future outperformance.