Under-performance of value investing

One of the best-established ‘anomalies’ in investing is the value premium. Over long periods of time, value stocks have substantially out-performed growth stocks. Over the last decade or so, however, growth has trounced value. On the other hand, even over the last twenty years, value investors have been well-rewarded. Blackrock’s Dr. David Ang provides a cogent overview of the value anomaly. It is worth exploring potential causes for this situation and the broader implications.

In brief, value stocks are those with low stock price relative to the underlying value of the firm, while growth stocks have high stock prices relative to the value of the firm. The relative differences in valuation are caused by expectations for earnings growth. Value investing is all about buying companies when they are cheap. Growth investing is a bet on potential. In theory, both current value and growth potential should be reflected in the current stock price, which is itself consensus opinion of the market as a whole. There are long periods during which growth out-performs value and vice versa, with value providing a substantial net benefit over very long time frames. Value’s recent under-performance is severe but not unprecedented (the fourth-worst since the 1920’s).

There are several possible explanations for the poor performance of value stocks and an exploration can inform discussion of other market dynamics.

1. We are simply experiencing the cycle between value and growth
2. Current measures of value are flawed or out of date
3. The historical value premium was a proxy for something else
4. The value premium has, in fact, diminished or disappeared

The first two of these are commonly discussed.

The first of these is the most obvious. In market cycles of all kinds, people start to lose faith and that is partly why anomalies persist. In principle, no characteristic of companies should be persistently under-priced. Markets should learn over time and adjust to reflect new data. The data suggests, however, the investors become enamored of growth vs. value in some periods and value vs. growth in others. When one is out-of-favor, it becomes increasingly compelling as it becomes cheaper.

The second explanation for the under-performance of value is very interesting. Using book value as a measure of the true underlying value may be creating strange biases. As Dr. Ang notes, calculating the actual underlying value of a firm was much simpler when the value of a company was mainly determined on the basis of physical assets like factories or train tracks rather than assets for the economic value is hard to quantify–like data sets or proprietary algorithms.

The third potential explanation for the poor returns of value relative to history might be that the measures of value were actually capturing something else and that low price-to-book is not the underlying cause of the anomaly. What if certain industries that tend to have low price-to-book values enjoyed a period of robust out-performance that has passed as the economy has evolved from industrial to technology-focused? Aside from changes in dominant sectors, there are also massive changes in corporate finance. Historically, the value premium has been strongly associated with dividend growth and value stocks typically paid higher dividends than growth stocks. Today, many fewer stocks pay dividends at all.

My bet is that the value premium will re-emerge, as it has done in the past. People are currently losing faith in value as the basis for investment. As such, value stocks are increasingly cheap relative to growth. At some point, we will reach a tipping point at which bargain-hunting value investors will start to pour assets into these unloved companies and they will reap excess returns, as they have done in the past. The very nature of value investing keeps this anomaly alive.