The Case For Value Stocks

By Jack Forehand, CFA

One of the biggest lessons I have learned in my investing career is the importance of being able to argue the other side of something I strongly believe in. Confirmation bias is one of the biggest enemies of successful investing. It leads us to seek out information that agrees with our position. It causes us to follow people who tell us what we want to hear. It makes us avoid those who disagree with us or to dismiss their arguments quickly.

I have written over 100 articles now, and one of those articles was read by more than twice as many people as any of the others. That article, The Case Against Value Stocks, also has the distinction of being one of the only articles I wrote that argued a position in opposition to my personal opinion. It also was the article I learned the most from writing because it forced me to challenge something that I had just come to accept was true; that value stocks would continue to work in the future like they have in the past.

Although I certainly learned a lot from the process of writing that article, it also had the side effect of making me most known for something I don’t actually believe. In an effort to no longer be “that guy who wrote the article making the case against value stocks,” I have decided that I should at least make an attempt to make the positive case, if for no other reason than to do my small part to get karma working back in the favor of value. And because it is what I actually believe.

So here is my case for value stocks.

[1] Value Stocks Are As Cheap As They Have Ever Been

It sounds a little weird to say that value is a value, but on a historical basis, that is exactly what it is. This chart from a recent article by Cliff Asness, founder of AQR, provides some excellent context on just how cheap value is on a relative basis.

By all metrics, value is very inexpensive relative to growth, and using anything but Price/Sales, it is as cheap as it has ever been.

Cliff’s article also does an excellent job refuting some of the more popular ways that opponents of value have tried to justify that cheapness, including some I wrote about in my original article. He found that excluding the largest stocks doesn’t change things. He also found that excluding expensive stocks doesn’t change things. And excluding technology stocks doesn’t either. No matter how you look at it, value stocks are at or near the cheapest they have been in history on a relative basis.

[2] The Reasons Value Works Still Hold

One of the major reasons value investing works is because investors tend to systematically overestimate the problems that companies that are going through difficult times are having. That doesn’t mean that most value stocks don’t have significant problems. They obviously do. And many of them will not recover from those problems. But on average, across a group of value stocks, the severity of the problems is typically overstated.

So the question becomes, are investors behaving better now than they have historically? Are they able to better control this overreaction? And as a result, is the market properly pricing value stocks now when historically it has not? Obviously, these questions are all very difficult to answer empirically. Using the past decade as an example, you could certainly argue that this effect is no longer present. But if there is one thing I have learned in over a decade of managing money, it is that no matter how much things change over time, investor behavior remains fairly consistent, since it is a function of the way we are wired as human beings.

The second reason that value works is because it is riskier, and historically investors have been compensated for that risk. How you define risk can obviously be subject to interpretation, but whether you look at risk as volatility or tracking error or the chance of significant periods of underperformance, it is hard to find anything in the past decade that would lead to the conclusion that value is no longer riskier than the market.

[3] This Has Happened Before

When I see any investing approach that works over the long-term that is going through a difficult period, I am always comforted if I can find previous periods where something similar happened, and it was able to bounce back. With value, there is substantial evidence of this. The period most of us remember the best is the late 90s, where many called value dead. Those of us who believe in value can only hope this period will end with the kind of relative outperformance that one did. But if you look back even further, there are several examples of long periods where value didn’t work, including the period from 1926-1941 identified in O’Shaughnessy Asset Management’s paper Value is Dead, Long Live Value, which was even longer than the current one  And at least thus far, all of these long-term periods of underperformance were not the death of value investing. That doesn’t mean that this period won’t be an end to that trend, but it does give us some confidence that value has overcome similar problems in the past.

[4] The Data Isn’t Telling Us Value is Dead

The goal of the academic research into factors is to find things that help to explain the long-term movement in stock prices. Value is one of these things that has helped to explain long-term returns. If a factor like value no longer works, you wouldn’t expect to see negative correlation with excess returns. What you would expect to see is no correlation. You would expect to see randomness where the two things have little to do with each other. That is not what we are seeing with value.

In addition, the length of the current period where value hasn’t worked is far too short to draw statistically significant conclusions as to whether it no longer works. Corey Hoffstein wrote a great piece on this topic where he looked at various factors and the length of time it would take before they could be declared dead with statistical significance. For the Price/Book ratio (the value metric he tested), he found that this period Is 67 years.  We are nowhere near that.

The Case for Value

When you sum all of this up, you have a factor that is as cheap it has ever been using a variety of metrics. You have similar examples of extended underperformance throughout history, all of which were followed by a significant period of outperformance. You also have no evidence that the reasons it has worked historically are no longer valid.  Finally, there is nothing in the data that would allow us to conclude with statistical significance that value no longer works. That makes for a pretty compelling long-term case in my opinion.

None of this means that there isn’t a case to be made against value. I still think some of the arguments I made in my previous article have merit. It also doesn’t mean that there is any way to know how long the underperformance of value will go on. I don’t think there is any way to predict that. But when all is said and done, I remain a believer in value and I think that those who stuck with it during this period will eventually be rewarded. In the end, I think the case for value stocks is a better one than the case against them, even if my most read article will always be the one that took the other side.   

Photo: Copyright: 123rf.com / ismagilov


Jack Forehand is Co-Founder and President at Validea Capital. He is also a partner at Validea.com and co-authored “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies”. Jack holds the Chartered Financial Analyst designation from the CFA Institute. Follow him on Twitter at @practicalquant.