By Jack Forehand, CFA, CFP® (@practicalquant) —
I have always been a big believer in value investing. The idea of buying companies at discounted prices has always resonated with me. And the fact that academic research supports value has given me all the reason I need to take that personal belief and translate into my investing approach.
But believing strongly in something often puts us at risk as investors because it can blind us to the arguments on the other side. For that reason, I have tried to periodically challenge my belief in value throughout my career. I first did it four years ago when I wrote about the case against value stocks. Then I took another look at it and tried to build on that case a couple of years later.
Now that another two years have passed, I guess it is time to challenge my belief in value again. And you can argue that now is actually a much more important time to do it since value is finally working and my confidence in it has risen along with that improved performance.
Here is a look at the arguments against value investing I made in those two articles with an update on how strong they are now relative to then.
[1] Federal Reserve Policy Changed the Game – Current Verdict: Weaker Than Before
I argued in my original article that Federal Reserve policy that kept interest rates and inflation low was bad for value. Although the evidence supporting the argument that low rates benefit longer duration growth stocks is mixed, the evidence supporting value working better when inflation is higher is stronger. But either way, low rates and high availability of capital allowed investors to focus much less on the cash flows that value companies generate in the present and much more on the potential of growth companies in the future.
This is the argument that has most changed since I originally wrote about it. When I wrote that article, many investors (including me) thought the low rate and low inflation environment would stay with us a long time. That has changed rapidly in the past year. Now rates are higher, inflation is higher and growth companies that were purely focused on growth are now scrambling to generate cash flows. And many of them will not be able to do it. This is a strong positive for value relative to growth. The one caveat is that we can’t say for sure whether higher inflation and rates will persist. A shift back in the other direction could be a headwind for value and help growth companies.
[2] There Are Too Many Value Investors – Current Verdict: Still Weak
One of the issues with factors is that if too many investors follow them, it can lead to a reduction or elimination of the premium associated with them. To think about it in simple terms, what would happen if the capital following value went up by 10x tomorrow and that change was generated by growth investors abandoning that strategy? The result would be buying pressure on value companies and a rise in their price and selling pressure on growth companies and a decline in theirs. This would narrow the valuation spread between value and growth stocks because value stocks would become more expensive and growth stocks less expensive.
Because we can calculate these spreads on a daily basis, we have a way of testing whether this is happening. And the data shows it is not.
The chart below shows the spread between value and growth stocks using the current year PE. It is in the 7th percentile for the period beginning in 2006.
Source: https://www.validea.com/market-valuation
So the expansion in relative multiple we would expect if too many people were buying value stocks has not materialized.
[3] Big Data is a Risk to Traditional Value – Current Verdict: Worth Watching
The idea here is that there is much more data available today than I can find on a company’s financial statements. Hedge funds know what is happening with credit card charges at a company. They can use satellite imagery to look at a retailer’s parking lot to see if there are cars there. You could argue that they get a head start on seeing future fundamentals that way, which gives them an advantage over investors who rely on waiting for the fundamentals to come out. Unfortunately, whether that advantage hurts other value investors is very difficult to figure out so there is no clear conclusion here. But I do think the idea that value investors may need to go beyond traditional fundamental data in a new technology driven world has merit.
[4] Value is a Bet Against Technology – Current Verdict: Mixed
Value strategies tend to underweight technology stocks. And when they do buy tech stocks they tend to buy those on the more boring end of the spectrum. That was obviously a major headwind for value performance for a long time. But it has now become a huge tailwind as high growth technology stocks have plummeted and cheaper stocks both within and outside of technology have done much better.
The first thing to acknowledge here is that value doesn’t have to underweight technology. Many firms follow sector neutral value strategies and maintain similar sector weights as the market. But even then, if high growth technology outperforms lower growth technology, an effective underweight position still exists.
If you are a believer that fast-growing technology companies will be long-term outperformers, then this could be a long-term issue for value. But the data tells us that high growth companies on average underperform the market so that would be a change relative to what has happened historically.
There is also a measurement issue here. Traditional value strategies don’t do a good job of accounting for the value of intangible assets. This can prevent these strategies from seeing the true value that exists in many technology firms. So considering an adjustment to the way we measure value might make sense for all of us who utilize value strategies.
[5] The Economic Cycle is Getting Smoother – Current Verdict: TBD
In my original article, I referenced the research of Ehren Stanhope of OSAM, who showed that value stocks tend to perform best around recessions. He included this chart in his article that shows how factors perform across the economic cycle.
This fact that value works better around recessions in and of itself is not necessarily a problem for value. Where the potential problem comes in is in a situation where we have a permanent reduction in the number of recessions. You could argue that would be bad for value if it gets much of its outperformance during these periods. And we have had less recessions in recent decades.
But the reason I listed this as TBD goes back to point #1 above. If the fact the inflation has been kept in check allowed policy makers to respond more aggressively to recessions, then persistently higher inflation could take that ability away. This could actually be good for value. But the verdict is still out on that since none of us know how permanent what we have seen in the past year is.
Is Value Back?
In the end, this article probably generates more questions than answers. And in many ways that is the point. There is no investment strategy that exists that we can be 100% confident in going forward, regardless of what its past record is. Without risk there is no return, Or as our friend Corey Hoffstein puts it, without pain there is no premium. The goal of exercises like this is not to eliminate all doubt about the future of value investing. It is instead to embrace that doubt to see what it can teach us about improving our approach going forward. So while I remain a big believer in value, I will do my best to continue to challenge that.
Talk to you again in 2 years when I do this all again.
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.
