By Jack Forehand, CFA (@practicalquant)
When you look at the long-term performance data of the major investing factors, value and momentum typically rise above the rest. A few weeks ago, we began our look at the basics of factor investing by taking a look at momentum. In this article, I will take a look at the principles of value investing.
Although value is usually the most intuitive factor for most investors, why it works, and how it is best implemented in the real world can both be more difficult to understand. But before we get into the why and the how, let’s first talk about the what.
What is Value Investing?
On the surface, value investing is very simple. It involves trying to acquire a stock at a discount to some measure of its business. That measure could be a flow-based measure like earnings or sales or cash flow, or it could be a stock measure like book value (assets minus liabilities). As a value investor, I want to try to acquire a business for less than I think it is worth. I want to purchase it for less than the present value of the future cash flows I expect it to generate.
And that is where the definition begins to get a little murkier.
For those of us who are systematic value investors, the definition of value investing typically involves buying companies that are “cheap” using the metrics I discussed before. But it is also perfectly reasonable to view value in a broader sense and to look at it as buying any company for less than its long-term value. By this definition, Google was much more of a “value” five years ago than the inexpensive stocks that would have made up a traditional value portfolio. The reason gets back to the idea of discounting future cash flows I talked about earlier. Google has grown its business at such a rate that what looked like an expensive valuation five years ago ultimately ended up being a cheap one in retrospect. So I have no qualms with those who say that something can be a “value” without being cheap relative to current fundamentals. But for the purposes of this article, I am going to talk about value in the academic context, which focuses on buying stocks that are cheap using standard metrics.
Why Does Value Work?
Your first reaction when you read the title of this section is probably that I am asking the wrong question. If you look at the returns of value in the past decade, the first question to ask isn’t “why does value work?”. The question is “does value work at all?”. I have looked at the arguments against value in other articles, and some of them are compelling, but in this article I am going to rely on the 80+ years of data that show that a value premium does exist, and not the past decade that has caused some to call that into question.
There are two distinct ways to tackle why value works (although they are very intertwined). The first is the academic argument.
From an academic perspective, systematic value investing typically works for two reasons. The first is that value stocks are typically riskier than the market, and investors receive a higher return as compensation for that risk. Value also typically goes through extended periods of underperformance, and investors who can sit through those periods have historically been compensated for doing so.
The second reason that value works is that it capitalizes on investor behavior and takes advantage of the mispricing created by it. Investors typically over-estimate the problems with value stocks and therefore drive their prices down further than is justified. Value investors benefit from this mispricing when the market eventually realizes that things aren’t as bad as they seem.
Another way to look at why value works uses a more practical framework. When you invest in a company, there are typically three ways you can make money. First, the company can grow its earnings. Second, the multiple investors are wiling to pay for those earnings can rise. Third, the firm can return capital to you via a dividend or a buyback. Value stocks typically yield more than the market, so the third component offers value investors an excess return over time. The second component (multiple expansion) typically also has been a benefit for value investors for the reasons above. When investors overreact to the bad news surrounding value stocks, their multiples are compressed. And then when reality comes in better than expected, value investors get some multiple expansion. The first component is the one that is typically not as good for value investors. Value stocks may grow at a comparable rate to the market. They may also grow at a slightly lower rate over time. But either way, they typically do not exceed the market’s earnings growth rate. But that effect has been offset by the first two historically, so on a net basis, value investors have received an excess return.
This video clip from our podcast interview with Alpha Architect’s Wes Gray explains this concept in more detail.
What are the Best Ways to Measure Value?
Building a systematic value portfolio is very simple on the surface, but much more difficult behind the scenes. The first step is figuring out how to represent value. Some practitioners have a favorite value metric they like to use, while others prefer to use a composite of factors. If you look at the long-term performance of all the major value factors, EV/EBITDA and Price/Cash Flow typically come out on top, while Price/Book (which is the most widely used value factor) trails the others. But the performance differences between the factors are not massive. The idea behind using a composite of factors instead of picking one is that it can be very difficult to figure out which factor will perform best in advance. But on the other hand, the factors other than Price/Book are highly correlated, so if you are using one of those factors, the benefits of a composite are not nearly as significant.
How Does Value Work with Other Factors?
Value tends to work well with both quality and momentum.
With quality, there are two schools of thought for how it can be combined with value. The first is the “Warren Buffett” approach of trying to buy high quality companies at the cheapest prices possible. This has the advantage of avoiding the bad businesses that will often pop up on many value screens, but it has the disadvantage of reducing exposure to value. Put more simply, high quality companies are typically less cheap, so to get something (quality) you have to give something else up (value). The other way quality is often used with value is as a negative screen. With this approach, instead of trying to buy great companies at a discount, I would instead just try to filter out the absolute worst ones. This has the advantage of maintaining more exposure to the value factor.
Momentum and value tend to make great partners because their excess returns are negatively correlated. So when value is struggling, momentum can help to pick it up. This is what has happened in the past decade. The other way momentum can be used with value is as a filter to help identify entry points. Since value stocks can stay out of favor for a long time, waiting for positive momentum to develop before purchasing them can help to enhance returns.
Critiques of Value
Given what has gone on in the past decade, coming up with critiques of value isn’t very difficult. But for investors who have studied value over the long-term, what has gone on isn’t really that far outside of expectations. And that leads right into the first critique, which is that value has typically experienced long periods of underperformance and generated its excess return over much shorter periods. This makes value extremely difficult to stick with for your average investor.
The other major issue with value is that there are legitimate arguments to be made that it won’t work as well in the future as it has in the past (I discussed many of these arguments here). And given how long it will take for that question to be answered, by the time we figure it out, it will likely be too late for many investors who follow value. As is the case with any factor, the risk exists that past performance will not be indicative of future results.
The Future of Value
Sometimes two things can be true in investing that seem to contradict each other. With value, I personally believe that it will outperform in the future. I also believe that most investors shouldn’t follow it. The reason for that comes back to the return profile of value I discussed before. Value can produce massive outperformance at times (like it has in the past six months). It also can underperform for exceptionally long periods (as it did in the decade before that). Asking most investors to sit through a decade of underperformance waiting for these big short bursts of outperformance is just too much in my opinion. So while I continue to believe in value long-term, I think most investors should either avoid it or couple it with other factors like momentum to help during the long periods where it struggles. Although I think the future of value is bright, the ride to get there will likely be a rough one.
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.