Value investing isn’t dead, it’s just sleeping
Co-Authored by Adrian Warner, Chief Investment Officer and Sam Morris, Senior Investment Specialist. The following article also appeared in Morningstar, October 15, 2020.
Value investing is dead, or so the headlines would have you believe.
The performance of US tech stocks during this year’s market selloff have not helped its case, and its historical performance over the last 14 years—down 51 per cent—is difficult to ignore. But there are reasons for the underperformance, and if you dig deeper, a solid investment case can be made in favour of it.
Value is one of the oldest, most intuitive styles of equity investing, and is often defined as a strategy that aims to pick stocks trading at a discount to their intrinsic value. The common short-hand is investing in stocks that have cheaper, accounting-based valuation ratios than the broader market, such as price-to-earnings (P/E), or price-to-book (P/B).
Before tackling value’s underperformance, it’s worth noting just how severe it has been over a long timeframe.
US stock value (HML) drawdowns – 1926-2020
Graph shows data from Professor Ken French. As of March 2020, Value factor is down -51 per cent from the peak reached 14 years ago. It is the longest and largest drawdown in value’s recent history.
We think there are four key narratives around value’s underperformance compared to growth.
Firstly, value’s underperformance can be summed up as, “This time it’s different”. Old economy stocks don’t justify a return to previous valuations and revenue growth rates, when compared to the new breed of “big tech” capital light businesses.
This hinges on the belief big, monopolistic (i.e. winner-takes-all) technology and e-commerce platforms will continue to grow at the same rate without meaningful competition or substitution. It also assumes traditional businesses are under threat from these new economy firms, and that they don’t innovate, integrate or compete effectively.
Secondly, it’s argued new economy “glamour” stocks with fast revenue growth and scalable business models don’t capitalise their spending on brand, IT, human resources, and research and development.
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, tangible asset-rich, low-growth old economy firms. This reflects on the most traditional, academic definition of value being P/B.
Investment in intangible assets is running at twice the rate of tangible assets in the US, causing a systematic misidentification of what value is. Adjusting for this intangible asset investment by capitalising it, so it appears in the book value of assets on balance-sheet, means new economy firms are better value when using traditional value metrics.
The third factor is the declining number of professional analysts covering stocks outside the mega-cap growth names, which magnifies the above trends. This concentrates investor attention at the expense of lesser known names. While we believe this decline in research presents opportunity for active managers, the reduction in equity research reduces the efficiency of price formation.
Finally, low interest rates, and the associated lower hurdle rate of return (known as the discount rate) exacerbates demand for long duration stocks. Investors seek stocks with potentially large, but less certain and more distant profits, at the expense of firms with proven business models and more predictable near-term cashflows.
Therefore, investors are 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 short-duration stocks. This has manifested itself in the outperformance of growth compared to value stocks.
How should value investing work?
What is value? The simplest explanation can be found in a dictionary, not a textbook. The Oxford English Dictionary defines value as, “The worth of something compared to the price paid or asked for it”.
Active investors are trying to find stocks that are worth more than the current price, and passive investors buy everything, assuming all prices are correct. Passive investors rely on active managers to set the price. To be incentivised, active investors must believe there are securities where value is greater than price. They must get in early, find the bargain and wait for other investors to realise and buy until value equals price. This describes every long-only investor’s process, irrespective of how they define value.
It’s important to remember the price 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 valuation.
It’s reasonable to expect growth stocks, whose future expectations don’t materialise, will suffer sharp price reversals. According to renowned tech commentator, entrepreneur and academic Scott Galloway, Amazon, Apple, Google, Microsoft and Facebook need to add more than $USD500 billion in revenue over the next five years to justify their revenue multiples if their implied promise to investors is to double the stock price over that time. That is a staggering amount of money and will result n aggressive competition.
Sometimes the market forgets these principles, but fundamentals usually rule over the long term. That is not to say some growth companies have not exceeded the expectations of early investors, it’s just that the performance of these stocks drove the entire market recovery after the first stage of 2020’s sell down.
For a long-only investor in order to make money the market must begin to agree for the price convergence to happen. Two things can make this a reality. The market can upgrade its assumptions about the prospects for higher future cashflows, or it can lower its implied discount rate of future cashflows, increasing their worth.
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.
Investors who have favoured value stocks over expensive growth, or momentum stocks have suffered on both counts. Market consensus about future growth and the potential scale of addressable markets of glamour stocks, combined with lower discount rates has been a perfect place for growth investors to thrive over the past decade and the early stages of the COVID-19 downturn.
The fact the return to systematic value investing has almost entirely come from multiple past expansions, not earnings growth, intensifies the problem.
Are the inputs to traditional value investing dead?
But this debate starts incorrectly. Many value investors begin with Benjamin Graham’s focus on low P/B value “cigar butt” companies—so cheap and distressed that one last puff is enough to generate a return—or the academic factor of low P/B or P/E definitions.
This frames the construction of value indices, which typically sort the market into quintiles or terciles based on some combination of P/B, P/E, price-to-sales or dividend yield and mechanically invests in the lowest ranked stocks.
Recent quantitative research finds value as a factor, irrespective of the metrics used, offers close to—if not the most attractive—relative value and potential upside ever seen in modern financial history compared to growth stocks.
If statistical, backward 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) have for a more contrarian-minded investor seeking greater value exposure?
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—defined as the equity value originating purely from expected cash flows.
This study finds that companies have increasing number of “non-productive” intangible assets like goodwill on their books. When you reclassify and exclude this “unproductive” capital, the outperformance of the top 10 per cent of stocks ranked on a “fundamental-to-market” ratio remains constant over time—at about 8 per cent a year since 1973—compared to the bottom 10 per cent of the same ranking system.
This compares very favourably with the traditional, unadjusted, price-to-book value investing, where the cheapest 10 per cent of stocks used to outperform the most expensive 10 per cent by over 10 per cent a year (from 1973 to 1996), but now outperform by less than 2 per cent a year (1996-2018).
This highlights the importance of looking beyond simplistic measures of backward accounting and beginning to understand the fundamental drivers of long-term, cash-flow driven value, or intrinsic value.