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Is This Time Different for Value Investors?

Jeremy Grantham broaches the subject.

John Rekenthaler, 05/16/2017

Optimists and Pessimists
For growth-stock investors, every day is a new beginning. There are always fresh industries to be invented, monopolies to be created, record profits to be earned. The growth-stock buyer is the child on Christmas morning, bounding down the stairs, wondering just what delights lie under the tree. Or the puppy, tail wagging, ready to step outside that door and explore what the world offers.

No such delights for value investors. They know what awaits their eager rivals: bitter disappointment. Santa's gift turns out to be a hand-knit scarf that looks suspiciously like Aunt Edna's hat. The puppy is yanked by his leash and is never permitted to catch the squirrel that taunts him. And that sure-to-succeed cupcake chain goes bankrupt, outdone by donuts.

The value investor, in short, is burdened by experience--the knowledge that as surely as night follows day, growth companies' bright prospects will dim. However, there is compensation for living in gloom. Historically, the stock market has rewarded those who study the lessons of history, and who therefore avoid the giddy mistakes.

Grantham's Early Years
One notable example has been Jeremy Grantham, co-founder of the asset-management firm GMO. When Grantham entered the investment business in 1965, he skipped straight to adopting the old man's approach of value investing. From Grantham's perspective, Ben Graham had already done the hard work, documenting how "the important ratios always went back to their old trends." So why not do as Graham advised? Buy downtrodden companies and wait for the mean to revert.

Writes Grantham, "And [it] worked! For the next 10 years, the out-of-favor cheap dogs beat the market as their low margins recovered. And the next 10 years, and the next. Not exactly shooting fish in a barrel but close. Similarly, a group of stocks or even the whole market would shoot up from time to time, but eventually--inconveniently, sometimes a couple of painful years longer than expected--they would come down. Crushed [profit] margins would in general recover, and for value managers the world was, for the most part, convenient, and even easy for decades."

Grantham was smart--and lucky. Give Grantham full credit for recognizing that he could profit by standing on others' shoulders, and for finding among the very best shoulders to mount. However, he enjoyed the good fortune of being born in 1938, not 1968. Had he waited a generation, he would have entered the business in the mid-1990s. Since that time, value investing has largely failed.

The Party Ends
The approach hung on for a while with smaller-company stocks. Since Jan. 1, 1995, the Russell 2000 Value Index has comfortably outlegged the Russell 2000 Growth Index, gaining 10.74% annualized as opposed to the growth index's profit of 7.77%. However, that advantage comes solely from the beginning of the period. Over the trailing 15 years, the two indexes have posted almost identical returns.

(Thus, our hypothetical younger Grantham, if put in charge of a small-company stock fund, would have posted an outstanding gain during his fund's first seven years. The fund likely would have attracted considerable attention and new assets, after which its performance would have sunk back to earth. This story would then be fashioned into a morality play--about the wickedness of funds that thrive when they are small, but which then take in too many new assets and become bloated.

is vice president of research for Morningstar.

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