The Value vs Growth Debate

These are a sample of headlines of articles and papers on the topic of whether “value” investing, as opposed to “growth” or “momentum”, investing will reverse its poor performance. This has been exacerbated by the outperformance of US mega cap tech stocks during the early stages of the COVID-19 equity market selloff.

Value investing is one of the oldest and most intuitive styles of equity investing. Often more formally defined as an investment strategy of aiming to pick stocks that are trading at a discount to their intrinsic value, the commonly understood short-hand is investing in stocks that have a cheaper statistical valuation ratio/s such as price-to-earnings (P/E) or price-to-book (P/B) than the broader market.

Here, will be to explore some of the published literature and recent commentary around why value has underperformed and then get back to fundamentals around how the discipline works when applied from a fundamental, bottom-up perspective and why it still has a place in portfolios.

Why has Value Investing been Underperforming?

Value investing is one of the oldest and most intuitive styles of equity investing. Often more formally defined as an investment strategy of aiming to pick stocks that are trading at a discount to their intrinsic value, the commonly understood short-hand is investing in stocks that have a cheaper statistical valuation ratio/s such as price-to-earnings (P/E) or price-to-book (P/B) than the broader market.

However, there is no doubt “value” has underperformed “growth” or “momentum” styles in recent times and this has been exacerbated by the outperformance of US mega cap tech stocks during the early stages of the Covid-19 equity market selloff. Before tackling some of the reasons for value’s underperformance as an investment style – at least when defined quantitively by traditional value investment metrics like price-to-book (P/B) and price-to-earnings (P/E) ratios – it is worth noting just how severe this underperformance is in a historical context.

US Stock Value (HML) Drawdowns

Source: Cowles at Yale.

As we see it, there are 4 key narratives around the underperformance of value stocks compared to growth stocks that we will outline below.

1) Winner-take-all economics (“Monopolies”)

To many, the principal reason for value’s underperformance can often be summed up as ‘this time it’s different.’ That so called ‘old’ economy stocks don’t justify a return to previous valuation levels and revenue growth rates when compared to the new breed of capital light business models epitomised by ‘big tech’. This narrative ultimately hinges on the belief that big, monopolistic technology and e-commerce platforms (i.e. winner take all) firms will continue to grow market share in the future at the same rate as in the past and continue extract rents from their ‘ecosystems’ without a meaningful competitive or substitution response. It also often assumes that traditional business models in many other industries are under threat from these businesses or general obsolesce, do not innovate, integrate these platform-style businesses into their existing business practices in a value accretive way and/or mount an effective competitive response.

2) Tangible versus intangible assets

One argument put forward is that new economy ‘glamour’ stocks with fast revenue growth and highly scalable business models with ‘winner take all’ (read: monopoly) characteristics, particularly in the business and communications services, software-as-a-service (SAAS) and biotech sectors, don’t capitalise their heavy, but valuable, spending on brand, IT, human resources, and R&D. This skews their book values downward compared to their share price, making them appear expensive on a price-to-book value basis compared to cheaper, low-growth ‘old economy’ firms [2] that have lots of tangible assets like property or plant and equipment. This ties straight back to the most traditional, academic definition of value being price-to-book (P/B).

One study quotes data that suggests that investment in intangible assets is running at twice the rate of tangible assets in the US[3]. This has caused a systematic ‘misidentification’ of what value truly is, and adjusting for this intangible asset investment by capitalising it so it appears in the ‘book value’ of assets on balance-sheet means that new economy firms actually start to look like better value when using traditional value metrics compared to old economy firms.

3) Lack of analyst coverage

It has also been argued that the trends outlined above are compounded by a declining number of professional equity analysts covering stocks outside of the mega-cap growth names that generate meaningful capital markets revenues for investment banks. This concentrates investor attention on these large cap stocks at the expense of less well-known stocks. Whilst we believe this decline in research coverage in many ways presents opportunity for active managers who do their own in-depth fundamental research, the overall reduction in in-depth equity research of less well-known companies arguably reduces the efficiency of the price formation by the market in less well known and/or smaller market capitalisation companies.

4) Interest rates and valuation discount rates

Another central argument is that low interest rates, and the associated lower hurdle rate of return (known as the discount rate) that investors need to invest in riskier assets, exacerbates demand for ‘long duration’ stocks. That is, investors seek stocks with potentially large, but less certain and more distant profits, at the expense of firms with historically proven business models and more predictable near-term cashflows.

It follows then that investors have been less willing to supply capital to these proven companies at the expense of financing the expansion of high growth firms, increasing their market capitalisations and access to financing at the expense of their ‘short-duration’ brethren. This has manifested itself in the massive outperformance of growth stocks compared to value stocks – which are at extreme levels of valuation dispersion.

How should Value Investing work?

But all of this doesn’t answer the question, what is ‘value’?

The simplest, and best explanation in our view can be found in a dictionary, not a finance textbook. The Oxford dictionary defines value as…

“The worth of something compared to the price paid or asked for it.”

It then follows that active investors are trying to find stocks that are worth more than the current price (i.e. value greater than price), and passive investors buy everything [4] assuming all prices are correct (that is, value equals price).

For this to be true, passive investors rely on active investors to set the price. And to incentivise active investors to do this, they must believe that there are securities where value is greater than price.

To crystallise this, they must get in early, find the bargain and wait for other investors to realise this and buy the investment until such time as value equals price. This basically describes the process that every long-only investor undertakes, irrespective of how they define ‘value’.
It is important to remember that the value of an asset in finance is meant to be the discounted value of future cashflows returned to investors. Assets whose statistical valuation metrics are higher (growth stocks) have larger future expectations of profit growth built into their present valuation than value stocks.

As such, it is reasonable to expect that growth stocks whose future expectations don’t materialise will naturally suffer sharp price reversals. According to renowned tech commentator, tech entrepreneur and academic Scott Galloway, Amazon, Apple, Google, Microsoft and Facebook need to add more than $USD 500bn in revenue to their income statements in the next 5 years to justify their current revenue multiples if their implied promise to investors is to double the stock price over that time period [5]. That is a staggering amount of money, around a third of Australia’s GDP, and will inevitably result in them competing aggressively against each other in industries like search, education, healthcare, financial services, cloud computing, retailing and advertising more broadly.

Sometimes the market forgets these principles in the way it prices companies, but fundamentals usually rule over the long term, as the management and private market investors in fast growing ‘unicorns’ like WeWork and Uber have discovered in recent years. That is not to say that some growth companies, notably US tech “FANMAG” companies (whose collective market capitalisations exceed all stock exchanges globally except the US market itself and Japan[6]) have not wildly exceeded the expectations of early investors. It’s just that the entire market recovery after the first stage of the COVID-19 sell down was driven by the performance of these stocks.

Cliff Asness of AQR Capital sums up why value works at all with this quote, “It does not depend on getting the big events or trends right. It does not depend on having perfect accounting information. Certainly, it does not require a lack of massive technological change over time. No matter what the situation, it simply needs investors to overreact. Companies that are cheap tend to be a bit too cheap for whatever set of facts exist at the time, and expensive companies need to tend to be a bit too expensive” (Asness 2020)[7]

Now, for a long-only investor who values an asset above its current market price, in order to make money, the market must begin to agree for the price convergence to happen. Two things can happen that make this a reality.1. The market can upgrade its assumptions about the prospects for higher future cashflows, usually based on changing views on the earnings of the company’s current business or projects it will invest capital into to expand the scope or scale of business.2. The market can lower its implied discount rate of future cashflows, thus increasing their current worth. This can happen either because overall interest rates fall or because the perceived risk of the firm’s cashflows are lower. The other way of saying this is that the market can decide to pay a higher multiple for the same earnings.

Historically, the best returns from value come about when both of those factors coincide, which often occurs in the initial stages of an economic and/or share market recovery.

As you can see, investors who have favoured ‘value’ (cheap) stocks over ‘glamour’ (expensive) or momentum (rising price) stocks have suffered on both counts above. Market consensus optimism about future growth potential and the potential scale of addressable markets of glamour stocks combined with lower discount rates, akin to lower risk premiums on the likelihood of that growth caused by falling interest rates, has been a perfect place for growth investors to thrive over the past decade and into the early stages of the COVID-19 economic repression.

The problem is compounded by the fact that, according to some studies8, the returns to systematic value investing (i.e. quantitative investing guided by historical financial metrics) have almost entirely come from multiple expansion in the past, not by earnings growth.

Are the Inputs to Traditional Value Investing Dead?

But where this debate goes wrong in our opinion is the starting point. Many value investors’ start with the traditional definitions of value in the tradition of Benjamin Graham’s focus on low price-to-book value ‘cigar butts’ companies (so cheap and/or distressed that one last ‘puff’ is enough to generate a return) or the academic factor of low P/B or low P/E definitions from the likes of Fama and French.

This then frames the index construction of value indices, which typically operate by sorting the market into quintiles (1/5’s) or terciles (1/3’s) based on some combination of price-to-book, price-to-earnings (“consensus”9 forward earnings estimates or trailing earnings), price-to-sales and/or dividend yield and mechanically investing in the lowest ranked stocks. Conversely, growth indices often use the same process, but use forward estimates of earnings per share growth rates, sales growth rates or momentum characteristics.

Recent rigorous quantitative research from renowned systematic investing firms like Research Affiliates10, AQR11, O’Shaughnessy Asset Management12 and others finds that value as a factor, irrespective of which metrics you use, offers close to, if not at the, most attractive relative value and potential upside ever seen in modern financial history compared to growth stocks.

Thus, if statistical, back-ward looking measures of value are at unprecedented levels of ‘cheapness’ relative to growth stocks, what place does fundamental stock picking (as opposed to quantitative, smart beta style approaches as outlined above) have for a more contrarian-minded investor seeking to take greater value exposure in their portfolios?

The impact of adding further qualitative sophistication to traditional value investing can be seen in a recent study from the University of Carolina, which re-classifies value as fundamental equity (FE) – defined as the equity value originating purely from expected cash flows.

Leading market commentator and research analyst Joachim Klement writes14 “[the authors] claim that since the 1970s accounting rules and corporate finance practices have changed significantly. Most notably, companies now have an increasing amount of capitalised goodwill and other intangibles on their books. These intangibles increase book value but are not a form of productive capital in the sense that they produce cash flows that are converted into dividends, share buybacks and other revenues for shareholders. They then calculate a fundamental value that excludes such unproductive forms of capital… When one then sorts stocks not on book-to-market ratio but instead on this fundamental-to-market ratio, the value premium does not disappear but remains constant over time.”

This highlights the importance of looking beyond simplistic measures of back-ward accounting and beginning to understand the fundamental drivers of long-term, cash-flow driven value, a.k.a. intrinsic value.

[1] Chan, R (2010) Behind the Berkshire Hathaway Curtain: Lessons from Warren Buffett’s Top Business Leaders. John Wiley & Sons, Inc.
[2] These ‘old’ economy, traditional value firms, which often operate in highly regulated (banks, insurance, utilities) or cyclical (retailers, transportation) industries have been out of favour.
[3] Lev, B. & Srivastava, A. (2019) Explaining the Recent Failure of Value Investing. NYU Stern School of Business
[4] Although index construction methodologies are in themselves, an active bet in our opinion.
[5] https://www.profgalloway.com/four-weddings-a-funeral.
[6] Arnott. R et al (May 2020), Reports of Values Death May be Greatly Exaggerated. Research Affiliates.
[7] Cliff’s Perspective (May 2020) Is (systemic vale investing dead)? AQR Capital Management.
[8] Livermore, J. & Meredith, C. & O’Shaughnessy, P. (July 2018) Factors from Scratch: A look back, and forward, at how, when, and why factors work. O’Shaughnessy Asset Management.
[9] Consensus earnings are the average earnings forecasts of sell-side equity analysis, those same sell-side equity analysts whose numbers are insteady decline
[10] Arnott, R. & Harvey, C. & Kalesnik, V. & Linnainmaa, J. (May 2020) Reports of Value’s Death May Be Greatly Exaggerated. Research Affiliates. SSRN 3595639
[11] Israel, R. & Laursen, K. & Richardson, S (March 2020) Is (systemic vale investing dead)? AQR Capital Management. SSRN 3554267
[12] Catherwood, J. & Fairchild, T (April 2020) A Historical Opportunity in Small Cap Stocks. O’Shaughnessy Asset Management
[13] Conclaves, A & Leonard, G (2020) The Fundamental-to-Market Ratio and the Value Premium Decline. Kenan Institute of Private EnterpriseResearch Paper, University of North Carolina. SSRN 3573444