Some people believe in Father Christmas. Others believe in the Tooth Fairy. And many investors believe that value stocks will outrun growth over the long-term and be a lot less volatile along the way.
Is the value advantage a myth that belongs in the land of St. Nick? Those investing during the growth-driven 1990s and 2010s would say yes. Academics and value-fund managers, on the other hand, would say no. Who's right?
As value strategies stage their long-awaited comeback, let's take a look at what is meant by the term value investing, examine both sides of the value/growth debate and explain what this means for your portfolio.
What is Value Investing?
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.
The idea is painfully simple: Buy stocks at prices below their intrinsic value and wait patiently for their market price to reflect their true worth. Graham looked for stocks selling at discounts to their net current assets and specifically those priced at 66% or less of the company's underlying current assets. Over a 30-year period through the mid-1950s, a portfolio of such stocks gained a hearty 20% on average.
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.
The Case for Value Investing
In subsequent years, countless academic studies proved that Graham was on to something. In 1986, for example, Harry Oppenheimer studied the returns of stocks listed on the NYSE and AMEX trading at 66% or less of their net current assets between 1970 and 1983. The mean return from net current asset stocks during the period was 29.4% a year versus 11.5% year for the combined indices. That same year, Roger Ibbotson studied stocks that were trading at low price/book and price/earnings ratios between 1967 and 1984 and found that stocks with low price multiples had significantly better returns over the period than stocks with high price multiples.
Studies that proved value investing's superiority continued to appear throughout the early 1990s. Eugene Fama and Kenneth French studied nearly 30 years' worth of monthly stock returns between 1963 and 1992. They showed that low price/book stocks outperformed high price/book stocks by, on average, 4.9% a year.
Risk entered the discussion in 1993. Josef Lakonishok, Robert Vishny, and Andrei Schleifer examined the investment returns of all NYSE- and AMEX-listed companies relative to their price/book, price/earnings, price/cash flow ratios between 1968 and 1990. The trio found that value strategies not only offered higher returns, but they concluded that value stocks were less risky, too: Value stocks generally outperformed growth stocks during the market's worst months.
The Case Against Value Investing
Despite what seems like overwhelming evidence in favour of value investing, this strategy faced challenges in the late 1990s and the 2010s. The chart below is a relative wealth chart that plots the performance of the Russell 3000 Value Index against the Russell 3000 Growth Index. When the line goes 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 has been losing ground since the second half of 2006.
Significant underperformance brought out the critics. And the critics raise some tough-to-refute points. Most notably that none of these value studies include the costs of buying and selling stocks and the studies involve regular trading or rebalancing - all of which eats into returns.
Detractors also question the idea that value stocks are inherently less risky than growth stocks - in other words, they don't buy the "margin of safety" concept. Although a portfolio of value stocks together may offer some margin of safety, that's rarely true of an individual holding. .
Philip Morris (PM) is proof of that. The stock entered 1999 trading with a price/earnings ratio in the low 20s, below that of the S&P 500. Value-fund managers argued that the stock was trading well below the value of its subsidiaries, Kraft Foods and Miller Brewing. By Graham's definition, the stock seemed to have a margin of safety. How much further could its price fall?
Evidently, quite a bit further. Continued tobacco litigation cut Philip Morris' share price in half in 1999. The stock's P/E withered to a sickly 7.2 by year's end. The lessons: Cheap stocks can always get cheaper, and a cheap stock isn't always a bargain. This is what's known as a value trap - and we have more details on how to spot one over here.
"Betting that the market has mispriced a stock is a risky proposition," Morningstar US manager research analyst Daniel Sotiroff says. "Forecasting future cash flows and discount rates is wrought with uncertainty because the future is unknowable. In 2020 for example, few would have guessed that a virus outbreak in China would rapidly spread around the world and slow the global economy to a crawl, spurning the near-term earnings of many businesses."
Finally, value stocks have been less reliable than growth stocks in some down markets, such as 1990's recession. That year, the average large-value fund lost 6.4% while the average large-growth fund lost just 2.4%. That's because many value stocks are cyclical and sensitive to economic cycles, struggling in recessions. Many growth stocks, however, thrive during recessions, especially stable companies in the food, beverage, and pharmaceutical industries. No matter how tough times get, we all need to eat and take our medicine.
This article contains extracts from the Morningstar Investing Classroom. Several Morningstar analysts have also contributed to this report including director of passive fund research Ben Johnson, manager research analyst Daniel Sotiroff and Morningstar Investment Management EMEA chief investment officer Dan Kemp.
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