Is Value Investing Dead?

Your kindly grandfather probably gave you great advice, like "Never make toast in the shower," and "Beets cause leprosy." He probably also told you that over time, value stocks outperform growth stocks.

It's hard to argue with buying cheap stocks for the long term. Unfortunately, value stocks have been lagging growth stocks for the past 30 years, which qualifies as long term for most people. The real problem might not be the notion of buying low and selling high, but the way value is commonly defined. It might be time for an update.

Let's go straight to the 30-year tape: The Russell 1000 Value Index has gained an average annual 10.29% during the past three decades as of this writing, which is certainly nothing to sneeze at. But during the same period, the Russell 1000 has earned 10.64%, while the Russell 1000 Growth Index has gained 10.56%. (All these include reinvested dividends.) The value index has also trailed during the past 12 months, five years, 10 years, and 15 years.

To give credit where it's due, the Russell Value 1000 has beaten the broader Russell 1000 the past 20 years, gaining 6.99% a year--exactly 0.01 percentage point a year more than the Russell 1000. The Russell 1000 Growth trailed both, gaining an average 6.44%.

What gives? Part of the reason for value's less than impressive performance stems from where we currently stand. Looking over the past three decades, growth stocks have had two periods of mammoth performance: from 1988 through 2000 and from 2009 through now. Furthermore, value stocks had truly wretched performance in the 2007-2009 bear market, plunging 47.18% versus 39.16% for the broader index.

Another problem is that bank stocks tend to be a favorite of value investors, because banks often have low prices relative to earnings. The Russell 1000 Value Index has 23.4% of its assets in financial services stocks versus 16.08% for the broader Russell 1000. Banks, unfortunately, tend to be at the heart of nearly every financial crisis in the nation's history. While the industry's near-death experience in the most recent bear market is hard to forget, remember that banks were about as popular as smallpox from 1988 through 1995, too, when 1,911 banks and savings and loans failed.

But there may be other issues with value investing, starting with the way that people typically understand the strategy.

"We've always balked at the idea that value means buying bad companies and waiting for them to become average," says Bill Nygren, manager of Oakmark (OAKMX). For one thing, bad companies can always get worse, as investors in Lehman Brothers learned a decade ago.

For another, short-handing value investing as "looking for cheap stocks" glosses over an important facet of value investing: To successfully invest in an unloved stock, you need something that will make it loved again.

"To fall back on Warren Buffett, value and growth are joined at the hip," says Wallace Weitz, manager of Weitz Value (WVALX). "If a stock price represents the future value of its cash flows, it's worth more if its cash flows are growing faster. A Mastercard (MA) at 20 times earnings can be much cheaper than a nongrowing savings and loan at 10 times earnings."

Today's value stocks might not look like your grandfather's value stocks.

"Buffett owns $50 billion of  Apple (AAPL)," Weitz says. "We've owned Visa (V), Mastercard, and Alphabet (GOOG)/(GOOGL) for years."

One reason for the difference that value managers are taking is that investors can, if they choose, get value factors easily and cheaply in the form of exchange-traded funds.  Vanguard Value ETF (VTV), for example, screens on several value metrics, including price to earnings and dividend yield, and delivers it all for 0.05% in expenses a year. The ETF has gained 5.79% this year versus 9.75% for the S&P 500 and 4.70% for the large-value ETF category.

"You have to stay a step ahead of the computer," says Nygren, whose Oakmark Fund is up 5.79% this year, as well.

Staying ahead of the computer means looking at metrics that are probably not in The Intelligent Investor, Benjamin Graham's classic guide to value investing. For example, value investors used to be wary of extremely large stocks, because they were often seen as less competitive than smaller companies.

"Today, the competitive advantage is with large companies--their moats become bigger because of their size," Nygren says. "We would argue, with the exception of Amazon (AMZN), FAANG stocks ( Facebook (FB), Amazon, Apple, Netflix (NFLX), and Google) don't look that expensive."

In the case of Alphabet, Google's parent company, investors are paying for the search engine, which accounts for about half the company's revenues. You're also getting a slew of other companies that aren't currently adding much to earnings, such as YouTube (Internet video), Waymo (self-driving cars), and GV, its early stage venture capital arm.

You could make the argument, too, that it's better to simply own the entire market--value or growth--and live a perfectly happy life without getting involved in the debate. To some extent, value and growth managers are simply buying and selling the same stocks at different times: Growth when they are expensive, value when they are cheap.

So is value investing dead? No. Traditional value investing has had an unusually long lagging period, which has followed an unusually bad performance during a bear market. Your grandfather probably would be surprised by the stocks that some active value investors are pursuing these days. Then again, he'd probably be surprised by Netflix, too.

John Waggoner is a freelance columnist for Morningstar.com. The views expressed in this article do not necessarily reflect the views of Morningstar.com.