by Richard Phillips, Chief Investment Officer
and Kevin Muir, CFA, Market Strategist
- Over the past century, value stocks have outperformed both growth stocks and the market as a whole.
- During the past decade, the value strategy has experienced uncharacteristically low returns causing a significant amount of pain for hedge fund managers and other investors who invest in quantitatively cheap companies.
- Although it’s tempting to proclaim that this time is different, it never is.
- The decline of value stocks offers a compelling entry point relative to growth stocks.
Albert Einstein once said compound interest was the greatest invention in human history. If Einstein were around today he would be better able to explain the magical effect of compounding, but in his absence, we are going to give it a whirl.
Let’s start with the lowest return. $1 invested in US Long-term Government Bonds in 1926 would be worth $134 in 2016. If you had the vision to invest in the riskier Corporate Bonds, that $1 would be worth $200.
But if you had the foresight to invest in equities, it would be dramatically better. Even with the worst performing equity strategy, the Fama/French US Small Cap Growth, which averaged an 8.8% return, you would be looking at $1,669 at the end of 80 years.
But what if we had gone with Large-Cap Growth instead? A 9.6% annualized return works out to $3,382.
Yet this difference almost pales in comparison to these next indexes. What if instead of just blindly buying the S&P 500, we do a little work on value stocks, specifically large cap stocks?
But here is the real stunner. By combining small-capitalization stocks with the value factor, the results are truly out-of-this-world.
It’s no wonder that some of the most celebrated investors throughout the ages have focused on the value strategy. Whether it is Warren Buffett, Peter Lynch, or Julian Robertson, they have all understood the tremendous edge that investing with this discipline offers.
But what is “value investing”?
Typically, it involves buying stocks with lower than average price to book ratios or lower than average price-earnings ratios. Of course, it’s not quite this simple, and there are many different flavours to the strategy, but at its heart value investing involves buying stocks that are cheap based on quantitative factors.
Yet isn’t that what all investors try to do? Aren’t we all trying to buy stocks that are cheap?
One might think this behaviour fairly self-evident, but in practice, it is much more difficult to implement. For example, in the current environment, which stocks are investors flocking to? Stocks that have a story. Stocks that are sexy. Stocks that are going up. Names like Amazon and Facebook. What stocks are investors avoiding? Stocks with challenging fundamentals like old-school conglomerates or those with disappointing themes that have made whole sectors cheap – like energy.
Although it might seem obvious to allocate to stocks based on “value investing” principles, in a real-world setting, it is extremely difficult to implement. To some extent, this is why the strategy has worked over the decades – if it were easy, everyone would do it.
The Death of Value?
Yet one shouldn’t expect an anomaly like this to exist without Wall Street trying to exploit it. This strategy of buying value stocks while shorting growth stocks has been a mainstay of long/short equity hedge funds for decades. Investing is a whole lot easier with the massive tailwind of this strategy’s alpha at one’s back.
The famed quantitative professor duo of Eugene Fama and Kenneth French even immortalized this strategy with their “three-factor model.” The first factor related to general market risk, but their seminal work described the two tendencies of small-cap stocks to outperform large-cap and for value stocks to outperform growth stocks.
This “Fama-French Value Factor” has been studied at length, with investment firms such as Goldman Sachs creating indexes based on instituting long positions in value stocks while shorting growth stocks. This index measures the relative outperformance of value over growth and demonstrates the tremendous amount of alpha this strategy has generated over the decades:
But there is a problem. The trend has been broken. We are now confronted with more than a decade of this strategy no longer working.
Historically, although the returns of the strategy have been volatile, the strategy’s alpha consistently reasserted itself enough to push value stocks back upwards relative to growth stocks. This has not been the case lately. Over the past decade, value stocks have languished as growth stocks have rocketed higher. To get a better sense of the pain felt by value managers during this cycle, a chart of the ratio of the S&P 500 value stock index to S&P 500 growth stock index illustrates the relative moves.
Here is a great article from CNN Money that ponders whether Buffett had “lost his Midas touch”:
Fast forward to today. There are plenty of similar articles questioning whether value investing is dead. Some might even question whether the Oracle of Omaha’s recent purchase of Apple represents a capitulation from the world famed investor.
One of value’s biggest celebrities, Greenlight Capital’s David Einhorn, has openly discussed the possibility that the strategy’s day in the sun has set.
Yet David’s words of frustration echo another hedge fund manager’s behaviour from the past. In 2000, a true giant amongst managers exited the money management industry. At the time, NY Times reporter Gretchen Morgenson wrote the following about Tiger Management’s Julian Robertson:
The financial markets humble ordinary investors all the time. In Julian H. Robertson Jr., head of Tiger Management, they have humbled an investing giant.
After 20 years of generating superlative investment returns by buying stocks that were undervalued and selling short those that carried excessive valuations, Mr. Robertson, 67, confirmed yesterday that he was shutting Tiger’s operations. He has essentially decided to stop driving the wrong way down the one-way technology thoroughfare that Wall Street has become.
As a frustrated value investor, Mr. Robertson finds himself in good company, like Warren Buffett, whose returns last year, measured by Berkshire Hathaway’s book value, rose a woeful half of 1 percent. Then there’s Robert Sanborn, a once-hot mutual fund manager, who resigned last week from his stewardship of the Oakmark Fund after a dismal 1999 in which the fund lost 10.5 percent.
…most of Mr. Robertson’s time will probably be spent with a handful of Tiger employees hunting for undervalued stocks. ”I’m looking forward to investing on my own,” he said. ”I’ve not believed in playing the markets. I’ve always believed fundamentals will win out.”
Investors often take money away from managers at the worst time. Julian Robertson closing his hedge fund proved to be the absolute bottom in the value stocks to growth stocks ratio.
And most importantly, it wasn’t the end of the strategy, but merely a hiccup. Yet that hiccup was enough to cause even the most ardent advocate of the value stocks strategy to pull the plug.
Soon after, with the DotCom crash just months away, investors abandoned growth stocks and flocked to the previously unloved value stocks. For the next five years, the value-over-growth strategy resumed its upward march.
Value stocks continued to perform admirably for the next half dozen years. But then financial markets experienced the greatest market disruption since the crash of 1929. The Great Financial Crisis was a seminal moment in many investors’ minds. Risk was abandoned. Equities were dumped. And it might seem that this would be a perfect environment for value stocks, but to almost everyone’s surprise, it proved just the opposite.
Value stocks were thrown out of investors’ portfolios. In the years following the market’s decline, as the global economy stagnated, it proved more difficult for average companies to grow. Increasingly, growth went to the industry leaders who were able to use technology, or access to limited credit, to dominate their industry. This nudged the economy more towards a winner-take-all environment. Combine that with the increase in passive investing and a host of other technical reasons, and you have a value-stock bear market when compared to growth stocks. The reasons are complicated and will be debated for decades, but the important thing to realize is that value stocks have been absolutely decimated relative to growth.
The Amazons and Facebooks of the world will always get more attention, but over the past decade, the actual returns of these high-flying companies have been stunning relative to boring, more reasonably priced value stocks. The relative decline of value stocks has been relentless and unmerciful.
Yet that begs the question – did something change in the Great Financial Crisis, or is this just a pause in the strategy’s long-term outperformance?
Time to consider a switch to value
There is no doubt that this cycle has unique features. Quantitative easing, negative interest rates, and central banks even venturing out to buy risk assets has turned traditional money management on its head. There can no denying that we have ventured into a new world of easy money that is completely uncharted.
But the hard truth is that there is always a reason to think this time is different. Each and every cycle there has been an excuse as to why “this time is different”. There is a reason those are known as the most expensive four words in the history of investing.
Although it’s so very tempting to think “this time is different” – it never really is.
We argue that it is time to consider switching to value because if we look back over previous cycles, no matter how different it looked, it was always the same. The value over growth strategy is a style of investing that sometimes falls out of favour, but has always returned when “new” era thinking disappoints.
It wasn’t different with the railroads in 1920s. It wasn’t different with the Nifty-Fifty in the 1960s. It wasn’t different with the DotCom bubble in the 2000s. And, we believe, it’s not different now.
What’s going to change?
It’s always difficult to predict a catalyst in advance. Often an investment seems so obvious in hindsight, yet real-world experience attests to the difficulties identifying those opportunities in the moment. If it were obvious, the opportunity wouldn’t exist. Therefore to some degree, buying cheap assets or strategies is a matter of faith. An investor isn’t certain what might make the investment appreciate, but simply believes that eventually the value will be realized.
Although we believe value stocks fall into this category, there are also some potential developments that might accelerate the process.
A possible catalyst for value stocks’ revival is the reversal of the trend of globalization. Increased global trade has been a huge deflationary force on the world economy. If that trend were to stop (or even reverse), it might result in higher interest rates, but also make it difficult for growth company leaders to capture an increasingly large portion of the global economy. Economic growth might shift back down to smaller companies that would be able to once again compete more easily. This would benefit value stocks that have been ignored due to their inability to grow in the global market.
Another reason for a potential shift from growth to value might best be summed up by Herb Stein’s line – “that which cannot go on forever, doesn’t.” Growth stocks have outperformed value stocks for good reasons, but for many of these companies they have developed an almost cult-like following. Investors are no longer soberly determining an appropriate price to pay for that growth, but are instead buying growth stocks because they are going up. Higher and higher prices become justified based on the price action. Eventually this sort of mania breaks. Although it’s always dangerous to predict when the bubble will burst, with last year’s popularity of FANG stocks and other public favourites dominating financial news networks it is clear we have hit a point where the story is well-known, and most likely, fully priced into the market. The danger is that when the tide turns, there will be few buyers left to sell to as everyone is already long.
But we believe the most important driver of value stocks will be interest rates. In a low-rate environment it makes intuitive sense that growth outperforms value. Growth stocks have a longer “duration” because the companies’ earnings power is pushed out further into the future. Investors are willing to pay more for future growth because the opportunity cost of today’s growth is lower. If we are to be entering into a higher-rate regime, then the days of investors paying up for growth might be coming to an end.
It’s not often such a reliable long-term money-maker as the value-stock-to-growth-stock strategy offers such a great entry point. For those that measure their investing in years instead of quarters, we believe the decline in value stocks versus growth stocks offers one of the few bargains out there. No doubt it’s a difficult pill to swallow. It takes courage to buy into this strategy after so many years of dismal performance. But this is exactly why it works. If it were easy, everyone would already be doing it.