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Value Investors Are Vexed

Value investing is simple in theory, difficult in practice.

Ben Johnson, CFA 18/04/19

The concept of value investing dates back at least as far as the 1920s, when Benjamin Graham and David Dodd first began teaching finance at Columbia University. The fundamental principles of value investing were later enshrined in the duo’s classic “Security Analysis,” first published in 1934.1 The idea is painfully simple: Buy securities at prices below their intrinsic value and wait patiently for their market price to reflect their true worth. Or as my grandfather used to tell me, “Investing is simple, buy ‘em cheap and sell ‘em dear. Did I mention that it’s not easy? Good luck!”

The approach, so elegant in its simplicity, ultimately evolved into a religion of sorts. Many of Graham and Dodd’s disciples, most notably Warren Buffett, rank among the most successful investors of all time. However, despite having basic intuition and legions of followers on their side, it wasn’t until 1992 that Graham and Dodd’s theory gained a rigorous empirical backbone. That was the year Eugene Fama and Kenneth French published their seminal work, The Cross-Section of Expected Stock Returns,”2 which introduced the concept of the value premium. The pair found that stocks trading at low price/book multiples tended to outperform those trading at high multiples over long time horizons. Fama and French showed that value was real, it was significant, and it could generate excess returns. However, their version of value was hatched in academia, a realm free of pesky issues like fees, trading costs, and taxes—real-world problems that might affect investors looking to harness the value premium.

Value “style” indexes were ultimately born out of these ideas. These indexes were at first designed to be style-appropriate benchmarks for active managers, and it was only later that they were adopted by index funds and exchange-traded funds. Their perfor­mance can give us a sense of the real-world value premium available to investors. From Dec. 29, 1978,3 through Feb. 28, 2019, the Russell 3000 Value Index gained 11.97% on an annualized basis, while the Russell 3000 Growth Index grew by 11.20% annualized. This 0.77% annual value “premium,” compounded over decades, netted a substantial increase in ending wealth. A US$10,000 investment in the value index grew to US$937,759.17 as of the end of February. The same US$10,000 invested in the growth index yielded US$711,476.79—a 32% difference. Clearly, Graham and Dodd were onto something.

Value Has Fallen Behind

Value investing is simple in theory, difficult in practice. Today, value investors find themselves in the middle of a particularly tough stretch. Exhibit 1 is a relative wealth chart that plots the performance of the Russell 3000 Value Index against the Russell 3000 Growth Index. When the line slopes up, the value index is outperforming. When it slopes down, the growth index is outperforming. You’ll notice that value got the best of growth for a stretch of six-plus years emerging from the aftermath of the tech bubble, but ever since the second half of 2006, value has been giving ground. From Aug. 8, 2006 (the value index’s growth-relative peak in Exhibit 1), through February 2019, the Russell 3000 Growth Index has outperformed its value coun­terpart by nearly 4 percentage points on an annualized basis. Value investors may be using their well-worn copies of “Security Analysis” as a doorstop and logging in to their Amazon Prime accounts (always a good value!) to order a copy of Philip Fisher’s (the so-called father of growth investing) “Common Stocks and Uncommon Profits.” 4

And It’s Been Falling Out of Favor

In fact, there is evidence that some value investors have been capitulating after years of watching growth outperform. Exhibit 2 plots trailing 12-month flows of investor capital into and out of value and growth mutual funds and ETFs across large-, mid-, and small-cap stocks dating back to the beginning of 1994. At the middle of 2015, the trend turned nega­tive for value funds, perhaps signaling that after nearly a decade of underperformance, value investors were throwing in the towel. And while there was a brief reversal that likely owed to value’s short-lived postelection rebound in 2016, investor sentiment appears to have more recently soured again.

Does Value Still Work?

Yes, value investing still works. I believe it always will because it is 1) intuitive and 2) at least partly driven—in my opinion—by bad investor behavior that will persist indefinitely. In fact, I believe the current outflows from value-oriented funds are evidence of exactly the type of behavior that will ensure the value premium will be with us for a long time to come.

This is how it might play out in practice: Fed up with years of underperformance, value investors will flee value funds and drive up prices elsewhere only to subsequently come down with a case of buyer’s remorse as their new funds of choice disappoint. Value will likely rebound, and those “value” investors will invariably chase performance back in the same direction they came from. The net result of this isn’t pretty for the performance-chasers, but their flightiness could yield long-term rewards for the steady hands—the true value investors. Remember: It’s simple, but it ain’t easy.

 

1 Graham, B., & Dodd, D. 1934. “Security Analysis.” (New York: McGraw-Hill)

2 Fama, E.F., & French, K.R. 1992. “The Cross-Section of Expected Stock Returns.” J. Finance, Vol. 47, No. 2, P. 427.

3 Note that this predates the July 1, 1995, inception of both the Russell 3000 Value and the Russell 3000 Growth indexes. Performance figures from Dec. 29, 1978, through these benchmarks’ inceptions represent back-tested performance.

4 Fisher, P. 1958. “Common Stocks and Uncommon Profits.” (New York: HarperCollins).

About Author Ben Johnson, CFA

Ben Johnson, CFA  

Ben Johnson, CFA is the Director of Passive Fund Research with Morningstar.