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Is There Any Value To Value?

Full disclosure: this is somewhat wonky post.  Still interested?  Read on!

Why have value stocks underperformed their growth stock counterparts for so long now?  I’m not totally sure (I told you this was wonky!).  But, I have debunked a couple of the common myths around value’s underperformance and offered a possible explanation below.

The virtues of value investing are well known in both academic and investment circles. The seminal work on value investing was done in 1992 by Gene Fama and Ken French, when they published their paper, “The Cross Section of Expected Stock Returns”. I’m oversimplifying what is one of the great written works in the history of finance but the paper effectively held that differences in long term returns could be explained by three primary factors: the market factor (stocks tend to outperform cash), the size factor (small stocks tend to outperform large stocks), and the value factor (value stocks tend to outperform growth stocks). Countless strategies have been created as a result of the Fama-French three-factor model and “factor investing” as it’s known has become quite popular within the investment community. For the purposes of today’s post, I’m simply going to focus on value investing and, by extension, the value factor.
 

What is Value Investing?

 
Value investing can be explained as follows:

Assets that are relatively cheaper tend to do better over long periods of time than assets that are more relatively expensive at time of purchase. For example, if I pay $0.80 for $1 of assets, my assumption is that this will outperform a similar investment where I paid $1 for that same $1 of assets. I paid less for the same thing…what’s not to like?

Intuitively, this makes sense…it doesn’t always work though. Take the last 10+ years for example, value stocks have wildly underperformed their growth counterparts as shown by the below chart:


 (Note: if the line is going up, it means value is outperforming growth, down means value is underperforming growth)
 

Why is this? There are a lot of different reasons offered in the financial media. Some of the more common narratives are listed below and I have added a few comments to each:
 

Narrative #1:
The proliferation of strategies tied to some form of value investing has rendered the space too crowded and thus these strategies are doomed to underperform.

 
This is probably the most common reasoning out there for why value investing has done so poorly and I also think it’s the most poorly constructed argument. In simple terms, if the space became overcrowded (as does happen from time to time), we would have seen an explosion in outperformance by value stocks when this overcrowding started to take place. This is classic behavior when a bubble is being created. Over the past decade, we’ve seen just the opposite.

I will grant that there are likely more value investors than ever today but those investors are suffering just like the rest of us and haven’t seen the typical signs of exuberance that are present when buying into a crowded trade. In short, no one seems to be able to offer any evidence that this is actually the case beyond the normal anecdotal proof.
 
 

Narrative #2:
Low interest rates have made growth stocks more attractive since their future earnings are worth more in today’s dollars than they would be in a higher interest rate environment

 
This is a more interesting rationale for value’s underperformance but, ultimately, probably an incorrect one. The theory holds as follows:

I can use interest rates to discount a company’s future earnings back to present day and determine a value of what I think that company is worth in today’s dollars (i.e. present value). If rates are lower, it makes the future earnings worth more to me and if rates are higher, then they are worth less. For example:

$10 received one year from today using a 3% discount rate is worth $9.70 today

$10 received one year from today using a 5% discount rate is worth $9.50 today

Still with me? Good. Now, I’m oversimplifying here but when a company has more of their earnings out in the future (i.e. they are depending more on future growth) and rates are low, a higher price is assigned to the those future earnings in today’s dollars (using the above math), which gives a huge advantage to growth-oriented companies (see: Netflix and Amazon) rather than value-oriented companies who are relying less upon future growth and more upon current earnings (see: Berkshire and Exxon).

The problem with this argument, and its ultimate undoing, is that there is no long-term correlation that exists between value and interest rates. Value’s underperformance happens to have coincided in this most recent cycle with lower interest rates but we saw just the opposite take place during value’s significant outperformance during the 2001-2003 interest rate cutting cycle.
 
 

Narrative #3:
Big data and increased computing power are rendering value strategies useless.

 
This one also feels like it could explain some of it but, ultimately, is also somewhat unfulfilling. Yes, I think computer power is increasingly a more important part of investing. Yes, I think big data is critical to understanding how markets trade today. No, I don’t think that this can adequately explain value’s underperformance. It just doesn’t make sense. If this was true, all stocks would trade at the same multiple and there would be no gradation in terms of valuation metrics. There is still a relative spread that exists in terms of the valuation of companies (some are more richly valued and some are more cheaply valued), which has been well documented and researched by our colleagues at AQR. As long as this is the case, which it almost certainly always will be, I have a hard time believing that computers are eating value’s excess returns.
 


So you’ve come this far…what is the answer, you ask?  Why hasn’t value investing worked over the past ten years as it did in the past?  Well…I really don’t know.  Sorry about that…but here’s my best explanation for what could explain it:

At the end of the day, I think the value factor is just a risk premium that is offered to investors willing to go against the grain for incredibly long periods of time. If you recall my earlier post on risk, you know that risk is really just the idea that more can happen than will happen; the last ten years have been the manifestation of that idea. Longer term underperformance, once considered a small and unlikely risk, actually came to pass.

Had you asked me ten years ago if value could underperform for the next decade, I would have told you that the data would suggest it was somewhat unlikely but not impossible. That’s the same answer I’ll give you today: value stocks seem to be reasonably priced for outperformance over the next decade so the data would suggest, but not even come close to guaranteeing, that outperformance.

Gene Fama, the above mentioned father of factor-based investing who won a Nobel prize for his work in the field, offered this assessment when asked recently about the underperformance of value stocks over the past decade:
 

Well, I don’t think there are real cycles to it. I think it’s just kind of random that you go through good and bad periods and, you know, you can’t recognize them except after the fact.

 
So…we just lived through a bad period…or maybe we’re still in one.  If it always worked, there would be no risk and, as you can probably imagine, no excess return either.  Finance is full of mysteries that will never be solved and the existence of the value factor is definitely one of those.  Will it turn around going forward?  I think so… but I can’t be sure.  What I can be more sure of, however, is that if you use value as a part of a well diversified strategy, you will likely do ok over the long haul… and that’s the best assurance anyone can offer you.