Updated Market Comments, October 22, 2020
Value Investing – Dead or Alive?
In our last commentary we highlighted one of our concerns for the market was the top-heavy nature of the S&P 500, especially in regards to large-cap tech and growth stocks that have driven market performance recently. We were delighted to have received feedback from investors who feel they are over exposed to these areas and are – sensibly – searching for alternative strategies that may potentially offer superior results going forward. Since the market’s inception, there is a bad habit that has plagued investors repeatedly, and that is to abandon the principles of value investing and not implementing a “margin of safety” during periods of market excitement (Hawley). By doing so, many investors may pay a price for their speculation as “overpaying for value” which can result in unsatisfactory financial outcomes. Back on July 29th, we wrote a commentary highlighting the potential opportunity in smallcap value companies (which is available to download and view on our website). We continue to see evidence that both small cap and value stocks have potential upside going forward. We would like to further comment on the re-emergence of value and how we believe that including value strategies in a portfolio can potentially reduce risk and add opportunities for outperformance.
The concept of “value” versus “growth” factors for stocks was popularized in the early 1990s by economics professors and Nobel laureates Eugene Fama and Ken French. They concluded that value stocks outperform growth stocks on average over time, relying on the academic definitions of value and growth. Value stocks can be defined in a multitude of ways, but the basic premise is targeting stocks trading at a low price relative to their underlying fundamentals. These fundamentals include low price-to-book, price-to-earnings, price-to-sales, etc. If the expectation is for prices to return to fair value implied by underlying fundamentals, then buying a discounted asset may reduce your risk.
Growth stocks in contrast are companies with sales and earnings that investors expect to grow faster relative to the market. These stocks usually trade at a valuation premium, as investors are willing to pay more for the promise of future earnings. As buying at a discount can reduce your risk, buying at a premium can increase it. There is appeal to owning value and growth stocks and the market makes deciding between the two difficult.
Currently, we believe value investing seems to be out of favor. It has underperformed against growth for so long, various media have declared “value investing is dead.” If your investment experience spans the last ten years, it is understandable why you may believe value is dead. In one year ending June 30, 2020, the Russell 1000 Growth Index increased 23.3% compared to an 8.8% decline for the Russell 1000 Value Index, outperforming 32.1% (please keep in mind Index returns are not fund returns as an index is unmanaged and not available for direct investment – past performance is no guarantee of future results). Over the last 10 years ending June 30, 2020, the growth index returned 17%, besting the value index by almost 7% (Hawley). However, if your experience runs longer, you would have a different perspective.
We highlight an analysis conducted by Lance Roberts of Real Investment Advice using data from Ken French and Dartmouth University. There have been only eight ten-year periods over the last 90 years (total of 90 rolling ten-year periods) when value stocks underperformed growth stocks. Two of these occurred during the great Depression, and one spanned the 1990s leading into the Tech bust of 2001. The other five are recent, representing the years 2014 through 2019 (Roberts). This comes to value outperforming growth in 91.1% of the 90 ten-year rolling periods from 1938 through 2019. Over the last 100 years, including the last ten, value has outperformed growth by 3.19% a year on average (Lebowitz).
We are strong believers in mean reversion, or the trend for extreme highs or lows for one asset class to eventually normalize closer to the long-term average. The current period of underperformance of value versus growth is the most extreme in both magnitude and duration. Since we believe in mean reversion, we believe that this period of underperformance will eventually revert to the mean, with value stocks catching up to and then outperforming growth stocks. Taking a look at what happened after the Tech bust of 2001, value outperformed growth by nearly 150% from July of 2001 to July of 2006 (Lebowitz).
Today’s market landscape is very similar to the 1990s. It seems investors are chasing the same type of growth stocks. There are some major developments in the current economic and competitive environment today too that may have reduced the usefulness of value investing based on traditional characteristics of value. One is that there has been a serious shift towards an economy focused on intangible assets. The second is the winner-take-most nature of internet-based businesses and the strong network economics that keep them competitively dynamic.
Historically, tangible assets (factories, equipment, etc.) were a company’s primary source of value creation. Today, the majority of value is created from intangibles (research and development, branding, etc). The S&P 500 Index’s market value associated to intangible assets versus tangible assets rose from 17% in 1975 to 84% in 2015 (Hawley). When a company creates more value from intangible assets, they will benefit from a powerful network. As more users and suppliers are added to their platform, their product becomes more valuable. Once the company gains a lead against peers online, it can grow rapidly and begin to take over market share, leading to potentially high returns on capital than market leaders experienced in the past. This makes it much more difficult in today’s economy for new entrants to successfully eat market share from leading companies, slowing the mean reversion process.
Buying a share of ownership in a company for less than what it is worth and waiting for value to be realized is still a very practical approach to investing. However, we believe simply buying stocks with low price-to-book or price-to-earnings ratios is not sufficient. Benjamin Graham was very supportive of the idea of implementing a “margin of safety” in investments. According to Benjamin, margin of safety suggests investors only purchase stocks when their price is significantly less than their intrinsic value. Under this premise, by buying at a sufficient discount, bad luck or the volatility of the business cycle should not crash the investment. Using a margin of safety is not as simple as it sounds. Most retail investors today do not research the companies they invest in. They watch financial media, websites, and tweets to give them direction. Or worse, they buy what is “winning” in the short-term. The reality is that you can only capitalize on the concept of margin of safety by researching a company’s qualitative and quantitative factors. Derive the security’s intrinsic value and then use the market price as a point of comparison to calculate your margin of safety.
When the market is overvalued by several metrics, finding value gets more challenging. It can get even more difficult holding value when it is underperforming the hottest stocks in the market. Timing a trend change is not easy. Growth may have already had its peak or it may have months or years to go. But the current period provides precious time to research and slowly add value to portfolios. The recent environment favoring growth has most likely created opportunities in more traditional value stocks for those who are able to navigate the competitive circumstances businesses currently face. We do not think value investing is dead but as the economy changes, the way in which value is measured should change too. What is smart at one price can be dumb at another – the price you pay matters.
“All persons ought to endeavor to follow what is right, and not what is established.” – Aristotle
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Past performance is not a guarantee of future results. All investing involves some degree of risk, whether it is associated with market volatility, purchasing power or a specific security, including the possible loss of principal. Stocks offer long-term growth potential, but may fluctuate more and provide less current income than other investments.
There is no guarantee that dividend-paying stocks will return more than the overall stock market. Dividends are not guaranteed and are subject to change or elimination.
Asset allocation and diversification are investment methods used to help manage risk. They do not guarantee investment returns or eliminate risk of loss, including in a declining market.
Index returns are not fund returns. An index is unmanaged and not available for direct investment.
The S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market value weighted index with each stock’s weight in the Index proportionate to its market value.
The Russell 2000® Index measures the performance of the 2,000 smallest companies in the Russell 3000® Index, which represents approximately 8% of the total market capitalization of the Russell 3000 Index.
Bloomberg Barclays U.S. Aggregate Bond Index is composed of the Bloomberg Barclays U.S. Government/Credit Index and the Bloomberg Barclays U.S. Mortgage-Backed Securities Index and includes Treasury issues, agency issues, corporate bond issues, and mortgage-backed securities. Investments in fixed-income securities are subject to market, interest rate, credit and other risks. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline in the bond’s price. Credit risk is the risk that an issuer will default on payments of interest and/or principal. This risk is heightened in lower rated bonds. If sold prior to maturity, fixed income securities are subject to market risk. All fixed income investments may be worth less than their original cost upon redemption or maturity. Yields and market value will fluctuate so that your investment, if sold prior to maturity, may be worth more or less than its original cost.
The prices of small company stocks are generally more volatile than large company stocks. They often involve higher risks because smaller companies may lack the management expertise, financial resources, product diversification, and competitive strengths to endure adverse economic conditions.
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Hawley, Austin (2020, July 13). Value Investing, Evolved. Diamond Hill Capital Management.
Lebowitz, Michael (2020, September 27). The Promise of Value Versus the Allure of Growth. Advisor Perspectives
Roberts, Lance (2020, September 23). Value, Margin of Safety, & The Art of Doing Nothing. Advisor Perspectives – Real Investment Advice.