Is Value Investing Dead?

Value investing has been around for nearly a century, developing a devout group of followers over time. Some of the world’s most prominent investors employ a variation of the strategy, including Omaha’s Warren Buffett. It’s not just the practitioners filling the ranks of the believers. The approach is also supported by academic research. Value investing has a strong track record with sound economic rationale to back why it has worked in the past and why it should work in the future.

None of this changes the fact that recently the relative performance of value investing has stunk (please excuse the technical jargon). For over a decade, it has lagged behind the broad market, causing some investors and pundits to lose faith. Here at Lutz, however, we still believe. To understand why, let’s explore what value investing is, how it has performed in the past, and why we are optimistic about its future.

What is Value?

“Long ago, Ben Graham taught me that ‘Price is what you pay, value is what you get.’ Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.” - Warren Buffett, 2008 Berkshire Hathaway Shareholder Letter

The above quote illustrates an important distinction that is confusing to many investors. How can you tell if a stock, or a broad market index like the S&P 500, is cheap or expensive? The obvious answer would be to look at its price. This approach feels natural, as many of us do it on a daily basis as we walk through a store or click around Amazon, but it can be misleading. The chart below illustrates the price index for the S&P 500 going back to 1928. If you tried to evaluate its merits based solely on price, you might reasonably conclude it was extremely cheap from the late 1920s to the 1970s. Aside from a few painful drawdowns in the 1990’s and 2000’s, the market appears to become more expensive year after year. The question is: If prices are always going higher, can stocks ever be cheap again?

Source: MorningstarDirect. The S&P 500 is represented by the S&P 500 PR Index, using monthly data from 1/1/1928 to 6/30/2019. 

This is where Buffett’s quote comes into play. It is evident we have paid more for stocks over time, but has anything changed in what we receive for our money? The answer, of course, is “yes”. Decades of companies reinvesting their profits to expand and develop new technologies have resulted in businesses that are larger, more efficient, and more profitable than ever.

There are many variations of the value approach employed by the investment community. A simple one seeks to evaluate how many dollars you must pay to purchase one dollar of some fundamental metric of a company or market index. Commonly used metrics include sales, earnings (think of earnings as profits), cash flow, or book value. The value approach is centered on making sure the price you pay is reasonable relative to what you get in return. When it comes to buying stocks, what you ultimately get is an ownership stake in a company (the book value), and the right to participate in its operations (its sales, profits, and cash flows). The intuition behind using earnings (profits) as an example is that returns will increase as you decrease the price paid for the same level of profits.

From here on, “value stocks”, or simply just “value”, will refer to the subset of companies where the price paid per unit of the above fundamentals is low relative to other stocks. If value stocks are those with the lowest price, the flip side of the coin would be growth stocks, or just “growth”. While it may seem counterintuitive to intentionally purchase the most expensive companies available, it’s actually a very popular strategy. The high-flying “FANG” stocks (Facebook, Amazon, Netflix, and Google) fall into this category. As their name implies, these firms are typically growing at a much faster rate than their value counterparts, and investors are willing to pay more for that future growth. The price may appear high today, but it could ultimately become a cheap purchase if the expected growth comes to fruition. The problem is investors tend to overestimate growth.

The Performance of Value

“In Theory, there is no difference between theory and practice. In practice, there is.” - Yogi Berra

The idea behind value investing is simple enough, but has it actually worked? To find out, we can compare the historical returns of value versus growth. Using data going back 91 years, the results clearly favor value, which outperformed the more expensive growth stocks by an average of 3.10% per year. While value has delivered higher returns over the long term, it has struggled notably in recent years. Over the last decade, the leadership has reversed with growth outperforming value by 3.44% per year. It is impossible to say precisely what has caused this change, but the massive returns from a small subset of firms (including the FANG stocks) have certainly contributed.

Source: The Kenneth French Data Library; https://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html. Value is represented by the Fama/French US Value Research Index, growth is represented by the Fama/French US Growth Research Index. The indices are not available for direct investment, do not include costs/fees, and are not representative of actual portfolios. Returns are annualized, based on monthly data from 1/1/1927 – 5/31/1927.  

After an extended period of underperformance, investors will invariably begin to question whether things have changed to the point the strategy is obsolete. While no one can say for certain if or when value will make its comeback, it is important to recognize the current bout of poor relative performance is not unprecedented. There have been several other notable periods where value has struggled.

Looking at the chart below, value has outperformed on a ten-year basis during the majority of the evaluation period, as evidenced by the green line fluctuating above the grey bar marking 0.0%. When the line is blue and below the grey bar (as it is today), it signifies growth has outperformed value. The aftermath of the Great Depression (1930’s), and the run-up of the internet boom (late 1990’s) provide two stark examples of past rough patches for value.

Source: The Kenneth French Data Library; https://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html. Value is represented by the Fama/French US Value Research Index, growth is represented by the Fama/French US Growth Research Index. The indices are not available for direct investment, do not include costs/fees, and are not representative of actual portfolios. Returns are annualized, based on monthly data from 1/1/1927 – 5/31/1927.  

Alas, no strategy works all the time. Value investing, like many other phenomena in the markets, is cyclical. Investors may shun certain companies for extended periods of time. This, in turn, makes them cheaper and may set them up to perform better in the future. Conversely, people can get overly excited about the prospects of certain companies. As more investors buy into the ever-rising growth expectations, the price could rise too far, setting the company up to underperform. Even a wonderfully successful company can be a subpar investment by merely delivering great results when the market was expecting perfection.

Value Going Forward

“There is no way that we can predict the weather six months ahead beyond giving the seasonal average." - Stephen Hawking, Black Holes and Baby Universes

Despite its struggles, there is a good reason to expect brighter days ahead for value. Given how well growth has done recently (particularly FANG stocks discussed above), the discount paid for value stocks is currently larger than normal. The chart below illustrates the discount for value companies (large and small) relative to the broad market. The middle grey bar in each section represents the average cost historically, while the green lines represent the current cost over time. The lower the green line moves, the cheaper value stocks are relative to the rest of the market.

Source: Morningstar Direct. Valuations are based on an equally weighted composite of price/book value, price/earnings, price/sales, and price/cash flow of each value index relative to the broad market. Large cap value is represented by the S&P 500 Value Index, while small cap value is represented by the S&P 600 Value Index. The broad market was represented by the Russell 3000 index. Data from 1/2001 to 6/2019.

As you can see from the chart, not only are value companies trading at a larger discount than average relative to the rest of the market, but they are the cheapest they have been since the early 2000s! Unfortunately, being a better deal than usual is not a guarantee that value stocks are poised to outperform in the near or even intermediate term. Over time, however, the price paid has been shown to be one of the best predictors of future returns. Generally speaking, the cheaper you can purchase stocks, the higher the returns you can reasonably expect (all else equal).

Wrapping Up

While the critics continue to debate whether or not value investing is dead, we believe those investors who are patient will be rewarded. The strategy has weathered many market cycles over the decades and endured other periods of extended underperformance. The opportunity to buy these already cheap companies at a larger than normal discount gives us a good reason for optimism.

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