Is This Time Different for Value Investors?

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.

In reality, though, the fund's problems would have owed to general trends in the stock market, rather than to specific actions that it took. The facts would have fit the thesis that small-company stock funds struggle to maintain their early successes when they become popular. However, in this instance, correlation would not have been causation. The relationship was accidental.)

With blue chips, value investing has delivered no benefit whatsoever since the mid-90s. From January 1995 onward, the S&P 500 Growth Index has actually beaten its sibling value index. The S&P 500 Value Index does lead slightly for the trailing 20- and 15-year periods, then lags just as slightly for the 10- and five-year windows. Overall, the competition has been a wash.

Those Who Wait When asked about this prolonged slump, value investors typically counsel patience. Yes, value stocks have not followed their historic pattern, but these things do happen. If risky investments had guaranteed periods of success, then they wouldn't be risky investments. Don't think of value stocks' struggles as a problem, but instead as an opportunity. The worse that the value style performs, the stronger its recovery when value investing returns to favor.

That argument makes much sense. It is a basic truth of investing that the rewards tend to be greatest when the prospects appear darkest. BusinessWeek headlined "The Death of Equities" in 1979--in hindsight, a terrific time to be purchasing stocks, not selling them. Two decades later, many wondered about the viability of value investing during the "New Era" of technology stocks. Value promptly had its best three-year stretch in years.

The claim also is consistent with human nature. It's difficult for almost anybody to revise their views when confronted with new evidence. It's especially difficult for mutual fund portfolio managers, who typically have reached a certain age, and who have enjoyed very successful careers. It's much more natural--and, usually, convincing to onlookers--to show "conviction" by reiterating long-held beliefs.

Brave Words Not so Grantham. In GMO's most recent quarterly letter, he entitles his article, "This Time Seems Very, Very Different." The headline is something of a tease, as the verb "seems" gives Grantham much wiggle room. Nonetheless, he does suggest the significant possibility that the conditions that supported the style of value investing that he learned from Ben Graham, and that he practiced himself for so many years, may be impaired. That is a bold thought from an established portfolio manager.

The next installment of this column, to be published on Friday, will examine Grantham's arguments. Why has value investing slipped? And what would need to change for value stocks to regain favor?

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.