With everyone freaking out about the “death” of the value investing, I thought I’d devote a blog post to my thoughts on why I think it’s much ado about nothing.
Also, for those who are easily triggered: I understand that value investing as a statistical factor is different from value investing as an analytical style used to evaluate the future cash flows of a company. When I talk about “value”, I’m talking about statistically cheap stocks.
The Value Anomaly
The academic literature treats value as an “anomaly.”
They say it’s a factor that explains anomalous returns. There is the market return, and value is a premium that you can earn over that. The hardcore EMH adherents will say that this premium is simply compensation for the additional risk of owning cheap stocks.
Size is described as another factor. This model explains why small-cap value has been the best investment strategy one could have pursued in the markets over the last 50 years or so.
If you knew that buying small, cheap stocks was a good idea on December 31st, 1971 and you could scrounge up $10,000 (assuming you could stop listening to Led Zeppelin IV and Who’s Next), you would now have $5,000,805, for a rate of return of 14.03%. If you opted for mid-cap value, you would have earned a 12.99% rate of return, which would have turned $10,000 into $3,234,830.
This compares to the US stock market return of 10.37%, which would have turned your $10,000 into $1,067,300. Large-cap value basically matched the performance of the US stock market, delivering a 10.3% return, which would have turned $10,000 into $1,035,393.
Actually implementing and sticking with the strategy would have been hard. There weren’t many low cost funds that could achieve this. You would have needed to do it yourself, which was hard in the era of high commissions. Moreover, you would have had to white knuckle it through some dicey times for the markets and the United States economy. Right after implementing the strategy in 1972, you would have lost 24.12% in 1973 and another 21.09% in 1974. I guess that most investors would have given up at that point, just when the strategy was about to rock.
Anyway, the “anomaly” exists. If you slice and dice it in different ways, other value factors work better. It’s also worth noting that the above results are based on price-to-book, which is a crappy way to describe value.
Is the value premium compensation for risk?
Value investing as a statistical factor is a subject of hot debate. There isn’t widespread agreement on what causes the premium.
The EMH crowd believes that the premium is compensation for heightened risk. Cheap stocks tend to be junky companies with uncertain futures, so they are riskier. Cheap shares in smaller companies ought to be even more dangerous, considering that a small company is more prone to failure than big companies. EMH adherents think of value and size in terms of a “premium” over the market return as compensation for risk.
I don’t agree with this. Take a look at the performance of small cap value during big, nasty, recessionary drawdowns. If value stocks are riskier, then the drawdowns during recessions should be more than the drawdowns for the broader market.
On average, small cap value declines with the broader market during recessions. However, the loss is typically limited to the broader market’s losses. In fact, it often outperforms.
On average, small cap value outperforms the broader market by 9.57%. Of course, this 9.57% average is skewed by the early 2000s, which was probably a freak event. This happened because in the late 1990s, small cap value was completely ignored by investors. Value investing famously fell out of favor in the late ’90s as investors became infatuated with the “new” economy. In 1998, small cap value suffered a loss of 2.68% while the broader market had an extraordinary 23.26% gain. In 1999, the pain continued. Small cap value delivered a paltry 3.35% rate of return while the market delivered 23.81%. As a result, entering the year 2000, the broad market was ridiculously overvalued and the value universe was overflowing with bargains that were ripe for multiple appreciation.
Even with that freak event thrown out, small cap value’s drawdowns are still limited to the market’s drawdowns during ugly recessions. If small cap value were a truly riskier strategy, the drawdowns should be a lot more severe than the broader market. This isn’t typically the case. In fact, small cap value still delivers a tiny premium of 2.53% for most of these terrible years, even when you throw out the early 2000s.
Small cap value doesn’t provide protection during most drawdowns, but the loss is usually limited to the market’s loss. If it were truly riskier, the losses should be much more severe than the broader market.
Meanwhile, value delivers incredibly robust returns when the economy is emerging from recessions and snapping back to life:
If small cap value were riskier, then these incredible returns in years like 1991 and 1975 should be offset by nastier drawdowns during recessions. However, this isn’t usually what happens. The drawdown is typically limited to the market’s drawdown and the recovery is usually more robust than the broader market.
And, this is using a crappy factor like price-to-book. If you use other factors like price-to-sales, price-to-earnings, or enterprise multiples – the results are a lot better.
This is also market-cap weighting value, which is further dragging down the returns. The returns in a value portfolio are usually in the cheapest securities, because they have the most runway to expand their multiples once the weather improves. The EMH adherents who treat value as a statistical anomoly usually market cap weight the value universe. They weight the stocks with the biggest market cap in the cheapo universe more heavily in the portfolio. A better approach would be equal weighting the universe or weighting the cheap names most heavily.
Meanwhile, value has underperformed for the last ten years, a phenomenon which is causing everyone to lose their minds and value managers to lose their jobs.
Value investors of the cheap variety are being mocked by everyone else who has bought the likes of Netflix and Amazon or simply invested in index funds. Most of the taunting amounts to “I bought VTSAX at 4 bps and made a ton of money, meanwhile these value nerds are killing themselves looking at cash flow statements and underperforming.”
Many of the value managers are capitulating to the bull market. They’re buying Netflix and Amazon and calling them value stocks because they’ve done a discounted cash flow model with optimistic assumptions about growth, margins, and interest rates. Then they quote something Buffett said about moats or Munger said about a tapestry of mental models. Ta-da, Netflix and Amazon are value stocks.
Since 2009, this has been the underperformance causing everyone to lose their minds:
Angels and ministers of grace defend us. Value investors have “only” earned a 13.82% rate of return for the last decade. How can they possibly sleep at night? What do they tell their children? Do they wear scarlet letters at investment conferences, hanging their heads in shame? Are they dragged through the streets while a nun rings a bell and shouts shame?
Obviously, this is ridiculous. Value has held up with the market and underperforming slightly, but this is hardly the scarlet letter of shame that the headlines suggest.
Yes, there are prominent value investors who have fallen from the heavens of the early 2000s, but most of their underperformance is due to the fact that they made outsize bets on individual stocks or outright shorted the market.
In the 2000s, shorting expensive stocks plus concentration in a handful of “best ideas” amounted to leveraging up returns and, likely, leveraging up egos. A decade of massive outperformance inflated the egos and confidence of prominent value investors, which caused them to continue to doing the same thing into the 2010s. The market gods sniff out arrogance like a bloodthirsty wolf, and the same strategy that worked in the 2000s amounted to leveraging their returns to the downside for the last decade.
Meanwhile, systematic long-only value investors quadrupled their money and mostly kept up with the market.
By the way this the “underperformance” is discussed, you’d think that value investors are chugging bottles of Pepto Bismol after spending their nights drowning their tears of sorrow into plastic bottles of vodka because of their paltry 14% rate of return that quadrupled their money in a decade.
The truth is that the death of value investing has been greatly exaggerated. Sure, it has underperformed, but only because the indexes have performed so wonderfully in the last decade.
Flat Markets & Bull Markets
The key to understanding the “underperformance” of value is to understand that value isn’t a premium at all. It’s an idiosyncratic return that is correlated to the market, but not a premium over the market return.
The return is caused by multiples changing. A systematic quant value investor is simply buying a bunch of stocks at depressed multiples. Why are the multiples depressed? Usually, there is some bad news with the underlying business and cause for concern. Why do the multiples expand? Mean reversion, like a force of nature, improves the fortunes of these businesses. The prospects of the businesses improve through microeconomic forces (i.e., competitors go out of business, prices increase, prosperity resumes). Meanwhile, the prospects of hot businesses grow worse through the same microeconomic forces. When business is good, competitors swoop in and kill a good thing. The stock market, meanwhile, tends to extrapolate whatever is going on right now and projects it into the future. This creates a consensus and a depressed multiple. When that consensus is reevaluated for value stocks, multiples expand.
This process even happens in markets that are in a secular bear market, like Japan in the ’90s and 2000s. In Japan, for instance, the magic formula strategy delivered a 16.5% rate of return from 1993-2005 while the broader market was destroyed.
Multiples for stocks are always expanding and contracting in dramatic ways. Stocks with a P/E of 5 are going up to P/E of 10. Stock’s with P/E of 50 are going down to 25. Even if the broader market is flat, this process is constantly happening within the market. Throughout the market, the prospects of stocks are constantly being reevaluated and the market is assigning multiples based on Mr. Market’s mood swings at any given moment.
As an example of Mr. Market’s insanity, take a blue chippy stock like JPMorgan. JPM’s 52-week low is $91.11. JPM’s 52-week high is $119.24. That’s a 30.9% difference. Has the actual underlying value of JPMorgan changed by 30.9%, or is Mr. Market a little crazy?
It’s this compresion and expansion of multiples that drives the return in a statistical value portfolio. This is a return that’s correlated with the market, but it isn’t a “premium” the way that the academics describe it.
This is why value truly shines during the flat markets when nothing is happening for the indexes, earning a seemingly insane level of outperformance. Take a look at the performance of value during two bad periods for the indexes:
Meanwhile, value’s underperformance during bull markets is nothing new. When US stocks are doing well, value either matches the market’s return (the ’80s) or it struggles to keep up (the ’90s, the 2010s). With that said, even when the strategy underperforms, the returns aren’t terrible.
Why does value deliver a decent return even while the market is flat? This is because value is always doing its own thing. There are always going to be stocks with depressed multiples which later expand, even during flat markets. It’s not a premium over the market return: it’s an idiosyncratic return derived from multiples constantly changing. During bull markets, value is always going to underperform. The long-term outperformance takes decades to capture because it mostly occurs during flat decades like the 1970s and 2000s.
I also don’t believe that that technology has destroyed value investing.
Value stocks have never been hard to find. Buffett combed through the Moody’s manuals in the 1950s. Investors in the 1970s could buy a copy of Value Line and find statistically cheap stocks. Now, investors can use screeners to find cheap stocks. Some say that this has elminated the “edge” for value investors. What these prognosticators of doom miss is that value stocks have never been hard to find. Value stocks have always been hard to buy.
It is hard to buy a stock with a depressed valuation. When you look at the company, there is usually good reason that the stock is out of favor. Everyone knows why they’re out of favor. Think about how ugly a New England textile mill looked in 1962 as it faced down cheaper competition. It’s just as hard as to buy the textile mill in 1962 as it is to buy a mall retailer facing reduced foot traffic in 2019. The hard part has never been identifying these cheap stocks, it’s actually going out and buying them. Technology makes it a little easier to find them, but it’s still just as hard to have the courage to buy them as it has always been.
There are also worries that the strategy has been overfarmed. Too many people are doing it. To which I ask: how many value funds out there have a significant active share in the cheapest stocks? How many fund managers have the cajones to really embrace the cheap stocks? How many are buying the truly out-of-favor securities? Most “value” funds and ETFs have an average P/E of 15 spread across hundreds of stocks. That’s hardly deep value land. They don’t actually buy the cheap stuff because few can handle the volatility and bouts of underperformance in a deep value portfolio. After a decade of underperformance, fewer are doing it than ever before.
Flat Markets & Bull Markets
Value investing, even of the statistical variety, isn’t going anywhere. The recent underperformance during a long bull market is nothing new.
If quadrupling your money in a decade causes you to throw in the towel, then buddy, maybe you don’t deserve the long-term value premium.
The outperformance, for those with a long time horizon, will come. It will come during the long stretches of time when the market is flat or delivering a low rate of return. I’m certain this is going to happen as much as I am certain that it will be cold in February. Markets are seasonal. They ebb and flow.
You might think that a flat market will never happen again. You might think that the market will deliver a 14% rate of return for the next ten years while every measure of market valuation is at historically insane levels. I think you’re probably wrong.
Valuations imply that we are in store for a decade of low returns. Pick your metric. Price/sales for the S&P 500 is at all time highs. Profit margins are at all time highs and profit margins usually mean revert. The CAPE ratio is 28.85. That’s not ’90s crazy (it was over 40 in 2000), but it’s currently where it was at the end of the 1920s boom. My favorite measure of valuation – the average investor allocation to equities – implies a 4-5% rate of return over the next 10 years. Vanguard agrees with that assessment and projects a 4-6% return for the next decade.
Those rates of return never happen in a straight line. A 5% rate of return is just the average of crazy returns. We’ll probably have years over the next decade where the markets delivers a 30% positive return and somewhere there will be a terrible year where the market suffers a 50% drawdown again.
Maybe the Fed has eliminated the business cycle and the world is forever changed. If you believe that: please pass me whatever it is that you’re smoking.
I’m betting that the next decade will provide low returns for US stocks. Meanwhile, Mr. Market will continue to increase the multiples of depressed stocks as their prospects change. As value investors systematically buy stocks with compressed multiples that later expand, the returns for value investors will likely exceed that of the market.
Perhaps I’m wrong, but I think this is the likely outcome based on history and common sense.
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