Few investment strategies work consistently. However, over the long run, buying value stocks – companies that are cheap based on “fundamental” ratios such as price/earnings (p/e) or price/book value (p/b) – has proved to be one of them. From 1926 to 2005, value beat growth (expensive stocks, loosely speaking) by 4.8% a year, say academics Eugene Fama and Kenneth French.
That’s a great track record. But recently, things have gone badly awry for value investors. Value has lagged growth for a long time, with growth (in the US, at least) outperforming by 0.7% a year for the last 12 years. Value enjoyed a revival last year. But its resurrection was short lived. It fell behind again in the first half of 2017, “more than wiping out its margin of victory from 2016”, says Mark Hulbert in Barron’s. What’s gone wrong?
The first problem, says Ben Snider of investment bank Goldman Sachs, is that the economic backdrop has been hostile towards value stocks. Growth has been weak, and interest rates low, which means investors are willing to pay up for stocks that demonstrate a genuine ability to grow, regardless of the backdrop (hence the popularity of tech giants such as Facebook and Amazon).
Another point is that value stocks just haven’t been that cheap. As Goldman Sachs notes, by 2013 the distribution of p/e multiples in S&P 500 stocks had tightened to “historical extremes”. In other words, loose monetary policy had lifted most stocks to trade on similar p/es, so few stocks were genuinely cheap.
However, these headwinds should diminish, particularly if interest rates rise and economic activity picks up. There are already signs of investor “rotation” from growth into value – at the end of last month, the iShares Core S&P US Growth exchange-traded fund (ETF) saw its biggest outflows ever, as investors pulled $103m from the fund. So should you follow them?
We like cheap stocks, and it’s nicer to invest in a given strategy when people hate it, rather than when they sing its praises. And as Snider tells Bloomberg, as long as human beings are involved in investing, and continue to overpay for growth, value should prevail in the long run. The only trouble is that right now even value stocks look expensive.
For example, the iShares S&P 500 Value ETF is on a p/e of nearly 22 – hardly bargain territory. So rather than fret over shifting from one basket of overpriced US stocks to another, we’d suggest value-hunters add to their holdings of any genuinely reasonably priced markets, such as Japan – or build up your cash reserves, ready to profit from any future market correction.