Is value investing finally set to see a long-overdue comeback?

Buying cheap stocks – value investing – usually works well. But it hasn’t for a while now. John Stepek looks at what’s gone wrong and asks if it’s due a turnaround.

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Buying cheap stocks normally works well.

It's one of the few ways that even the most humourless believers in rational markets agree that you can beat the market.

But "value investing" hasn't been working. And it hasn't been working for ages now.

What's gone wrong? And is a turnaround just around the corner (again)?

Here's why value investing works

In the long run, buying cheap stocks and holding them until they are expensive tends to pay off.

Now, I could launch into some long technical thing here about "factors" and "smart beta" and "efficient markets", and you could just switch off, because you've heard it all already and it was boring the first time.

So let's just put theories about rational markets and the rest of it aside for the moment, and deploy our common sense (which in this case, is more than adequate to the task) to explain why this is.

At the end of the day, we're all human. Stuff goes in and out of fashion. As social animals, we like winners and we shun losers that's the safest path. So winners keep winning and losers keep losing. That's why momentum investing works.

But life is cyclical. The wheel of fortune spins. Things change. Eventually some losers win and some winners lose. The people love an underdog who starts winning. And the pack is merciless to fallen heroes.

So if you can throw your lot in with an underdog before they start winning, you can expect a rapid ascent once their turnaround becomes clearer to everyone else in the market.

That's the idea behind value investing. Invest in companies who are temporarily down on their luck, because times change and, when they do, those companies will enjoy the best gains, because they'll go from being priced as "losers" to being priced as "winners".

And what with human behaviour being fairly consistent over time, this is the sort of feature that should be almost impossible to eradicate from markets. It's hard (though not impossible, I suspect) to arbitrage away a feature that is this deeply embedded in our DNA.

With me so far?

Here's why value investing hasn't worked recently

As Sean Markowicz of Schroders points out in a recent report on value investing, there are plenty of good reasons why value stocks have done poorly in the wake of the financial crisis.

One problem is that value stocks tend to be cyclical: they do badly in downturns, and then they have a cracking rally when the recovery phase arrives. The trouble is, that in the wake of the 2008 financial crisis, the "recovery phase" hasn't really materialised for cyclical stocks.

Also, interest rates have remained low. As Markowicz points out, that gives growth stocks an advantage over value stocks. Put simply, growth stocks are "jam tomorrow" stocks. But if interest rates are low, you can put a very high value on tomorrow's lovely self-spreading, laser-guided, AI-assisted, interfaces-with-your-fridge-via-your-home-solar-array jam, because there's virtually no cost to waiting for it to arrive.

Markowicz also makes another very interesting point growth stocks have been fuelled by lots of share buybacks, whereas value stocks have issued more shares. That's partly driven by massive share issuance from the financial sector following the crash.

So a tepid recovery accompanied by low interest rates is bad for value. Why is there any reason to expect that to change?

Firstly, says Markowicz, the gap between the performance of value and growth is now at its widest in many years. You'd expect that to close at some point, and the wider it gets, the more scope value has to outperform.

Secondly, growth stocks may become less appealing as spending on share buybacks declines (not to mention the risks of regulation across the technology sector).

Thirdly, as interest rates rise and earnings growth for value stocks improves (partly due to a recovering financial sector and also because rising rates suggest a healthier economy in general), you'd expect in relative terms if nothing else life to get that bit easier for value stocks and that bit harder for growth.

Given the current disparity in performance, you don't necessarily need a rampant recovery in value. You just need things to get "less bad".

In the latest issue of MoneyWeek (out today), my colleague David Stevenson looks at a number of cheap and simple ways to get wide exposure to value stocks. And my colleague Sarah Moore talks to two of Britain's top fund managers about their approach to finding stocks that can deliver fantastic long-term returns. If you're not already a subscriber, you can sign up here.

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