The road ahead for value investing

Many academic studies find that value stocks, those which have low prices relative to their earnings or book value, tend to out-perform growth stocks (those with high prices relative to earnings or book value). This concept also makes intuitive sense. Investors who are prepared to buy stocks that are cheap, because these companies have hit a rough patch or for which growth prospects are unexceptional, should reap some benefit. There are always investors clamoring to buy the exciting ‘glamour’ stocks (e.g. Tesla), but many will ignore the slow-but-steady firms that ultimately thrive. With both academic research and commonsense behind it, investing in value stocks seems like a good bet. The problem, however, is that value stocks have experienced an extended period of dramatically under-performing relative to growth. Value investors fully expect that they need to be patient, but many are concerned that our understanding of the value effect is incomplete or that, for other reasons, the value premium is dead.

The performance of value value stocks has substantially lagged growth for a very long time, and COVID has exacerbated this run. The iShares Russell 1000 Growth ETF (IWF), a growth index fund, has returned 21.3% per year over the past three years, as compared to 5.5% per year for the iShares Russell 1000 Value ETF (IWD). The advantage to growth is less extreme over the 10- and 15-year periods, but remains huge.

iShares Russell 1000 Value-2.750.875.528.4610.326.9
iShares Russell 1000 Growth29.6636.7521.3219.6216.811.93
Annualized percentage returns for Value vs. growth index funds through Nov. 13 (Source: Morningstar)

My own research into the expected performance of value vs. growth has suggested that value’s slump would persist. In April and in November 2019, I arrived at this conclusion on the basis of an econometric model, a statistical method for analyzing trends and variability in the performance of value and growth index funds (IWD and IWF, the same two funds in the table above).

When I perform the same type of analysis today, value (IWD) looks far more favorable relative to growth (IWF) than when I analyzed these two almost exactly a year ago. In fact, IWD is very slightly more attractive that IWF. The note of caution, however, is that neither IWD nor IWF looks very attractive on a econometric basis. The fundamental drivers are easy to understand. Growth looks to have plateaued and to be in the process of reverting to somewhat more rational valuation. Value appears to be recovering, but there is enormous uncertainty in the outlooks for many value sectors.

My current thinking is not that the value effect is dead, but rather that the ways that we calculate value are flawed. A compelling new paper finds that the traditional measures of value are incomplete because they do not capture the enormous and growing value of companies’ intangible assets in a global economy driven by knowledge and intellectual property. Many companies with substantial intangible assets could be mis-classified as growth stocks because the book value of the firm does not reflect the value of intangibles. More generally, this vein of research suggests that simplistic measures of value and growth may not be nuanced enough to evaluate when a stock is inexpensive relative to its current inherent value and growth prospects. My own investments are strongly tilted towards value right now, but not using a generic value index based on price-to-book or price-to-earnings.