As we observed in the US, value stocks all over the developed world underperformed horrifically from 2007 to 2020 (and in emerging markets from 2011 to 2020). But on the basis of their fundamentals—specifically their dividend distributions—portfolios of value companies did not. Investors expected the worst from value companies, and priced them accordingly, at ever-deeper discounts relative to the broad markets. But value indices soldiered on, delivering dividend growth roughly pari passu with the broad markets.

Robert Shiller won the Nobel Prize for his work showing that share prices are much more volatile than the underlying fundamentals of their respective companies. He suggested that this excess volatility, relative to the underlying fundamentals, was evidence of market inefficiency.⁹ This has direct relevance to the value crash of the 2010s. Value stocks crashed, all over the world, relative to growth and relative to the broad CW markets, but value companies did not. A rarely-discussed implication of this divergence between value stocks and value companies is the persistence of a “value effect,” even when value stocks were struggling. The value crash, all over the world, was wholly a consequence of a downward revaluation in value stocks, measured relative to their underlying fundamentals. Their fundamentals were doing just fine!¹⁰

History shows that value stocks’ dividends track those of the constituent stocks in broad market indices. When the dividends of one group falter, as they did during the global financial crisis, European/EM debt crisis of 2011, and the Covid crash, the dividends of the others follow suit. The dividend income of value stocks may be slightly more vulnerable to financial crises than the income of growth stocks, but not in a single instance since 1985 did value stocks’ income weaken enough to justify the relative performance routs they faced.

It bears mention that the dividends of value stocks do, as expected, grow more slowly than the dividends of growth stocks. Fama and French (2007) coined the term “migration” to describe a mechanism by which portfolios of value stocks deliver dividend growth similar to (and often faster than) portfolios of growth stocks. With each annual rebalance, growth stocks drop out of the growth index when their valuation multiples fall too far. These low-PB or low-PE stocks are replaced with new high-fliers, which reduces the book value or earnings base of the growth portfolio. The opposite happens with the value portfolio, with some stocks regaining favor in the market and trading at higher PB or PE ratios, and no longer qualifying for the value portfolio.¹¹ These are replaced with new unloved stocks at depressed valuation multiples. This means that the PB or PE ratio falls, hence the underlying book value or earnings will rise, with each and every rebalance.

Suppose an investor put $100 into the CW Global index at the end of 1996. With a yield of 2.02%, the investor would have garnered a modest $2.13 income stream. With income reinvested (and no taxes, trading costs, or spending to interfere with the compounding), that $2.13 dividend income would have grown, in currency-hedged terms, to $13.51 by the end of 2022. From equivalent starting points, dividends for the CW Global Value Index started at $2.39 and ended at $15.01. So much for the growth portfolio making up for a lower yield by delivering faster growth. Meanwhile, RAFI’s annual dividend income grew from $2.58 to $28.98, more than double that of the CW Global index.

The value investor sees an 18% higher income stream taper to a 12% premium after 26 years. That’s a long time for the growth investor to settle for less income in hope of faster growth! Meanwhile, the RAFI investor’s 27% income premium soars to a 118% premium in just 26 years. The growth records for US, Developed ex-US, and Emerging markets show a similar pattern in Appendix 5.

A simplistic worldview might suggest that the higher yield of a value portfolio and of RAFI is a tradeoff for less growth in dividends (and earnings, sales, etc.) compared with a more rapid rise in income for the growth investor. Absent the Fama-French migration effect, this is correct. Once migration bolsters the dividend income growth of a value portfolio, and impedes the income growth of a growth portfolio, this differential disappears. The value portfolio trades newly-lower-yielding stocks that no longer qualify for the value portfolio, in exchange for newly-high-yielding deep value stocks. The rebalancing alpha of RAFI is nothing more than this same Fama-French “migration” effect on steroids: while the value portfolio rebalances at the margin, with stocks added or dropped from the index, RAFI rebalances the entire portfolio, to a higher yield (and lower PE, PB and PS ratios) with every rebalance!

Suppose the relative cheapness of value stocks compared to the market—the essential reason for the higher yield on value stocks—were stable over time. In that case, the relative performance graphs for the RAFI and CW indices would—by mathematical identity—track the oh-so-steady spread between the dividend income lines plotted in the charts of Figure 5. The differences in the growth of dividend income would hardly justify the volatility we observe in the relative performance between growth and value, or between value and RAFI indices. A logical conclusion, then, is that the volatility in the excess return of value stocks relative to the broad market (which is of course strongly driven by high-flying growth stocks) is a consequence of constantly changing consensus market expectations regarding the future prospects for value companies relative to the broad market, with no empirical support for these fast-changing expectations.