By Jack Forehand (@practicalquant) —  

Confirmation bias is one of the biggest problems in investing. We all have a set of core beliefs, and we tend to surround ourselves with people who also believe them and focus on information that validates them.

For me, one of those things is that value stocks will beat the market over time.

There is no shortage of data to support value. The academic research shows that is has worked historically. And the work of practitioners like AQR, Research Affiliates and O’Shaughnessy Asset Management does the same.

But there is a danger in following only the people and data who support what you believe. It can blind you to the other side of the argument, especially when your beliefs are strongly held. And there is almost always another side.

As a supporter of value investing, it serves no purpose for me to pretend that other side doesn’t exist. Whether I believe it or not, I owe it to myself and to those who follow the models I build to be able to make that case and to understand how I might be wrong in the way I am thinking.

So I am going to use this article to do exactly that. I am going to make the case for why value investing may not work as well going forward as it has in the past. Here are some reasons that those of us who support value may be wrong.

[1] The World is Different

Ben Hunt at Epsilon Theory (who we will interview soon for our Five Questions series) makes this case better than anyone I have seen. If you haven’t seen his work, I would recommend you read The Three Body Problem where he makes this case much better than I can. But the general argument is that the Federal Reserve and other central banks have changed the game by engaging in large-scale asset purchases. They have encouraged risk taking without the consideration of fundamentals. And now that they have done it once, they will likely continue to do it going forward. In that type of world, things like value and quality may not matter like they have historically. At the very least, they may matter less and go through much longer periods where they don’t work.

[2] Too Many People Are Doing It

The amount of money chasing value stocks continues to rise. I have lost count of the number of factor-based funds that use some sort of value system and large firms like DFA have deployed massive amounts of capital into value strategies. In investing, whenever anything works, more and more people follow it. Since the publication of Fama and French’s three factor model, that is exactly what has happened with value. That has the potential to degrade or eliminate the value premium.

[3] The Capital Following it is Becoming More Permanent

It is counterintuitive in some ways to think like this, but followers of value strategies want other value investors to panic during periods of underperformance. That bad behavior is in part what makes it work. Permanent followers of the strategy who won’t panic no matter how long it underperforms can reduce its effectiveness over time. And as more investors become educated about the negative effects of their behavior, it is possible they will stick out the downturns more. The anonymous Twitter user Modest Proposal made this point in his podcast interview with Patrick O’Shaughnessy. If he is right, that is bad for value.

[4] Big Data and Rising Computing Power Are Leading to More Value Traps

The more data that is available and the faster it can be processed, the more efficient the market should become. That could mean that more cheap stocks are cheap for a reason. It could also mean that using historical fundamental information to predict the future will be harder. Let me give you a simple example. Say my value strategy really likes Walmart because it trades at a discount to the market based on a composite of metrics. But if other investors have other data outside of those fundamentals that paints a different picture, Walmart may be cheap for a reason I am not aware of. For example, they might have satellite images of Walmart parking lots across the country indicating that customer flow is down. Or they might have information from credit card providers that indicates that total sales are falling. Either of those could lead to a situation where the historical fundamentals I am using don’t paint a clear picture of reality and more cheap stocks could end up being value traps.

[5] Value is a Bet Against Technology

Unconstrained value strategies tend to make implicit sector bets over time. This can vary based on which value metric you use, but all of them tend to underweight technology. If you break down the underperformance of value over the past decade, you will see that one of the major reasons for it is that it had more significant weights than the market in sectors that have done poorly like Financials and below average weights in the technology sector, which has been the best performer. This isn’t necessarily a long-term negative because it can work both ways (if you owned value strategies in 2000, you were probably pretty happy they didn’t own technology stocks), but if you are a believer that tech will drive the market going forward, that isn’t a good sign for value. It is also important to note that this issue can be addressed by following a sector neutral value approach that keeps its sector weights close to the benchmark. But if you follow unconstrained value models, this could continue to be a drag on performance.

The Death of Value?

So does all of this mean that value investing will never work again? Is its future just filled with buying a bunch of cheap companies and watching them continue to disappoint? I don’t think so. Although all of these arguments have some validity to them, there are counterarguments to each of them that I think are even more valid.

The point of this exercise wasn’t to suggest that value investing is dead. The point was to show that there is another side of the argument. And that is true of almost anything in investing. It is true of investing in high momentum stocks. It is true of buying high quality companies. It is even true of buying index funds. No matter what style in investing you use, it is very easy to get caught up in a feedback loop that does nothing but support it. But by doing that you lose the ability to question yourself. You lose the ability to figure out how you might be wrong. Whatever strategy you are following, you should ask yourself whether you can do what I did here. You should consider whether you have looked at the other side. Whether you end up agreeing with it or not, the practice will make you a better investor.

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