Rumours of the demise of value investing have been exaggerated. But what could reinvigorate the strategy?
Is value investing dead? The popular investment strategy – which, at the risk of oversimplifying, just involves buying cheap stocks rather than expensive ones – has underperformed the wider market badly (particularly in the US) since the post-financial crisis rally began back in 2009. Josh Brown on The Reformed Broker blog noted last week that no fund manager tells their investors that “we buy the most expensive assets, and add to them as they rise in price and valuation”. A shame, he says, because it’s “the only strategy that could possibly have enabled an asset manager to outperform in the modern era”.
Value is well known as a “factor” (see below) that consistently beats the market over the long run. But frustration with the current state of affairs has led many to claim that we’re in a new era, in which value can no longer work because of big changes in the global economy, ranging from the persistence of low interest rates to the power of the internet, and so on.
And yet, as Larry Swedroe notes on the Alpha Architect blog, “there is really nothing unusual about value’s underperformance over a decade; it’s just that investors have poor memories and/or they don’t know their investment history”. A study by well-known investment researchers Eugene Fama and Ken French, stretching from 1963 to 2016, found that underperformance by value (and other “factors”) is common over three- to five-year periods, and “far from rare” over ten years. More pertinent still, adds Swedroe, is that today’s travails for value investors are similar to the dry spell suffered in the late 1990s. Back then, underperformance was driven primarily by tech stocks – today it’s again being driven by the technology sector and the likes of Facebook, Amazon and Netflix.
So why has value lagged so badly? One reason, says Swedroe, is that a world of low and falling interest rates and inflation is better for “long-duration” assets (ones that promise to deliver more of their profits further into the future, rather than today) than “short-duration” ones. Low-profit, high-growth tech companies fit the bill perfectly, while profitable but slow-growing traditional companies lose out by comparison.
What with the US central bank, the Federal Reserve, now deemed more likely to lower rates than raise them, it may seem as though today’s environment of loose monetary policy will never end. Yet perhaps value is now so cheap that it makes sense to have exposure anyway. JP Morgan’s US equity strategist Dubravko Lakos-Bujas notes that value stocks are currently as cheap, relative to growth, as they were in the tech bubble. One cheap exchange-traded fund option is Vanguard Global Value Factor (LSE: VVAL).
I wish I knew what a factor was, but I’m too embarrassed to ask
A factor is a characteristic of a share (or other asset) that has been shown to contribute to market outperformance. Research into factors was largely driven by academics trying to figure out why certain stocks tended to generate higher returns than theories about efficient markets would have predicted.
For example, widely accepted factors include size (the observations that small companies tend to beat large firms over time); value (cheap companies beat expensive ones); yield (high-yielding stocks do better than low-yielding ones); and momentum (stocks that go up just keep on going up). To be clear, these factors will not always beat the market over any given time period – but looking at historical data over the long run, they have generated superior returns in many different markets across the globe.
“Smart beta” is one trend in the investment industry that tries to exploit this using both the rapid growth in computing power and a growing sense of disillusionment with active fund managers. Smart-beta exchange-traded funds (ETFs) promise to use computer algorithms to build and invest in indices based on various factors. So you might invest in a momentum ETF that continually rebalances into momentum stocks, or a value ETF that does the same for stocks seen as cheap on measures such as book value.
One problem with the race to find new factors for smart beta to exploit is the risk of data mining – if you look hard enough at historical data, you can find apparently meaningful patterns that are in fact simply statistical flukes. However, it’s fair to say that the most deeply established factors (such as those listed above) are widely accepted as valid – although, as with value, whenever they endure a period of significant underperformance, there will always be people who question whether they still work, or if they ever did.