Valuation Spreads

David Nelson of Legg Mason writes about a historical chart of valuation spreads, which compares the top quintile of stocks (the cheapest 20%) to the market average.

As is visually apparent from the chart, valuation spreads are about as compressed now as they have been at any time since 1952. Spreads were similarly-but not as consistently-compressed for much of the 1960s and in the mid-to-late 1990s.

Goldstein's chart raises a couple of interesting questions, in our view. First, what is the investment significance of spread compression? And second, can we learn anything about the current market environment from analyzing past periods of valuation spread compression? I believe the answer to the second question is yes, but before we get to that, we need to answer the first.

Based on visual inspection of the chart and my own market experience, valuation spreads tend to be widest at, or near, major market bottoms-1974, 1982, 1991 and 2002. These are normally periods of high stress in the market, where most stocks are going down, but some sectors are getting absolutely killed. As this happens, the spread between the very cheapest stocks in the market and the average stock tends to widen out. In these environments, historically, the best investment strategy - though often the most painful if you're early - has been to load up on the very cheapest stocks (which are usually concentrated in a few sectors) and wait. If you don't get fired by your clients for owning really scary stocks first, you normally make a lot of money as the market turns and valuation spreads begin to narrow.

In contrast, market environments where valuation spreads are compressed tend to occur after the market has been doing well for a period of time. As the market advances, pockets of severe undervaluation get identified and exploited. Ultimately, this process of identification and exploitation leads to a market, such as we have today, where everything is priced the same. Obviously, that last statement is a bit of an exaggeration, but the spirit of the comment is true, in my judgment. In many industries and sectors today, we see little valuation discrimination between the very best companies and the merely average.

In market environments where valuation spreads are compressed, it would seem to make sense to focus on high-quality, high-return businesses that can grow, because you don't have to pay a premium-or much of one-for them. In short, it seems to us that it should pay to focus on growth stocks. That proved to be true in the mid-to-late 1990s, as well as the 1960s.