Is Value Investing Broken?

It hasn't been easy to be a value investor lately. The Morningstar US Growth Index has whipped the Morningstar US Value Index during the past several years--and things have been especially rough this year.

But at the Morningstar ETF Conference, a panel of value practitioners pointed out that it's never easy to be a value investor, and that value stocks today are behaving just as they should.

Moderator and Morningstar analyst Dan Sotiroff kicked things off with a broad question for the panel: Is the performance drought in value during the past decade simply a temporary lull or something more persistent?

"Value has been crushed," admitted John Ameriks, head of Vanguard's quantitative equity group. "There’s no magic strategy that's always going to work. But if you believe in this flavor of investing, it's been getting more attractive on a go-forward basis."

"The world is unfolding exactly as it should," added John West, managing director at Research Affiliates. Almost any factor or style of investing goes through 10 years of underperformance. To invest in any particular style, you need to go in with very a long time horizon, he noted--at least 10 years.

"The expected return of this strategy is 2%--plus or minus 10%," said West. Those unwilling to accept this possible range of returns in any given year shouldn't engage in value investing.

Along with a long time horizon and an ability to accept a wide range of returns, investing in value strategies requires the fortitude to invest in "uncomfortable" stocks, those that others won’t touch.

"You've got to own the pain, you've got to buy the cheap stuff everybody hates," argued Wes Gray, CEO of Alpha Architect. "You've got to own all this stuff that

And that's the premise behind value investing: cheap stuff outperforms expensive stuff over the long term. But what metrics are best to use to determine what's cheap: price/book, price/earnings, price/sales, or some combination thereof?

"There's no one right way to be a value investor," said Ameriks. The "right" metrics may depend on what company, type of stock, or sector you're considering.

"We try to use a broad array of measures," noted West. Further, the typical value metrics tend to track each other over the long term.

Some value managers will overlay additional criteria--say, a quality screen or a maximum sector percentage--to the process, in an effort to thwart risk and perhaps add a bit of extra return.

"You have to start with value, with the stuff that's uncomfortable," reminded West. "And then if you want to focus on higher quality, go ahead and maybe you can get some incremental improvement in return."

Though, conversely, adding too many layers of criteria can dampen the effectiveness of the value effect over time.

"It gets much harder as you add additional overlays," noted Ameriks.

Gray noted that the more you sector-neutralize, the less you're capturing the value premium.

"Anything related to Amazon is a value stock--retailers are correlated today," he said. "If it's all cheap because it's in Amazon's path, you need to own a lot of it."

Rather than adding too many overlays, value investors can instead diversify across a large number of stocks or own bigger rather than smaller companies--though the panelists agreed that, in general, most factors are more effective with small-cap stocks, due to less information and efficiency in that part of the market.

"The concept of not overpaying makes sense in large caps and small caps," noted Ameriks.

Though value investing can be trying at times, it's a commonsense strategy rooted in one basic investing principle: as prices go up, expected returns go down.

"It's called math," concluded Gray.