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The Performance Chase Is On in Value

Somewhat ironically, investors' bad behavior ensures the value premium's longevity.

Ben Johnson, 06/23/2017

A version of this article was published in the May 2017 issue of Morningstar ETFInvestor. Download a complimentary copy of ETFInvestor here.

In 2016, after years of underperformance, value stocks staged a comeback. The Russell 3000 Value Index outperformed the Russell 3000 Growth Index by about 11 percentage points for the year. All was right with the world, as relatively cheap stocks once again outperformed their relatively more expensive counterparts.

Here's an excerpt of an article I wrote on the topic in January 2016:

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 versus 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 Dec. 31, 2015, the Russell 3000 Growth Index outperformed its value counterpart by 3.89 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.

And It's Falling Out of Favor
In fact, there is evidence that some value investors are beginning to capitulate after years of watching growth outperform. Exhibit 2 plots trailing 12-month flows of investor capital into and out of value, growth, and blend mutual funds and exchange-traded funds across large-, mid-, and small-cap stocks dating back to the beginning of 1994. As of 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.

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. Here's how it plays 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 inevitably 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.

Ben Johnson is Morningstar’s Director of European ETF Research.

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