Value Investing Isn't Broken

A version of this article previously appeared in the June 2020 issue of Morningstar ETFInvestor. Click here to download a complementary copy.

Has the market become so efficient that the time has come to abandon value index funds? Information is more widely available now than ever, and the resources dedicated to processing and acting on it have never been greater. As a result, significant mispricing is less likely now than in the past. Yet despite these advancements and value stocks' lengthy stretch of underperformance, it's premature to give up on value index investing.

Is Value Investing Broken?
Value stocks have been out of favor for a long time. The Russell 3000 Value Index lagged the Russell 3000 Growth Index by a staggering 5.9 percentage points annualized from the end of 2006 through May 2020. That's enough to try almost any investor's patience. It's the longest stretch of underperformance that U.S. value stocks have ever experienced.

The world has changed over the past few decades in ways that critics of value investing argue reduce its efficacy. Among these changes: 1) Intangible assets and share buybacks have grown in importance. Firms that are more reliant on either of these things may look artificially expensive on price/book, as book value doesn't capture internally developed intangible assets and share buybacks reduce book value. 2) Interest rates are much lower now than they were before the global financial crisis, which some have argued creates a headwind for value stocks. 3) As awareness of the value effect has grown, more investors have incorporated it into their investment decision-making, which could reduce its efficacy.

Other criticisms are evergreen and point to the fact that simple valuation metrics are incomplete and say little about intrinsic value, which is unobservable.

The Case for Value Is Still Strong
AQR recently published a paper debunking many of these arguments (1). (This firm uses value in many of its strategies.) The authors looked at valuation measures that attempt to correct for perceived accounting deficiencies. But even with those adjustments, value still underperformed. This suggests it is unlikely that intangible assets or conservative accounting choices are driving value's underperformance. They also concluded that share repurchases didn't have a big impact on value's performance.

Similarly, it isn't clear that low interest rates disproportionately hurt value stocks, despite that argument's intuitive appeal. The thinking is that growth stocks' cash flows are further out in the future than value stocks', so they have longer duration and should benefit more from falling rates. However, unlike bonds, stocks' cash flows aren't fixed. They tend to contract during recessions (which is when rates tend to fall) and grow during expansions. On top of that, the equity risk premium tends to be procyclical. So, changing interest rates don't have a straightforward impact on the relative performance of value and growth stocks. Indeed, another paper from AQR found there was no significant relationship between the level of interest rates and the performance of an industry-neutral long-short value portfolio (2).

Interest rates could have a disproportionate effect on certain value-leaning sectors, but it isn't clear that falling interest rates are a net negative for broad value portfolios. For example, low spreads between long- and short-term rates tend to hurt banks. However, low interest rates tend to help utilities and real estate investment trusts, which are highly leveraged and have more stable cash flows than most.

The factor-crowding argument also doesn't do much to explain why value has underperformed. If it were at work, we would expect to see valuations between value and growth stocks compress. Instead, they have widened considerably over the past decade.

It's harder to dismiss the argument that simple valuation ratios don't say much about where a stock is trading relative to its intrinsic value. Each stock's intrinsic value is determined by the present value of its future cash flows. That, of course, is unobservable. What we see instead are prices relative to metrics like book value, sales, or earnings. Yet none of those paints a reliable picture of long-term cash flows.

Requirements for Value Investing to Work
Despite their flaws, simple valuation ratios can point to higher expected returns if investors either 1) systematically underestimate the cash flows of stocks trading at low valuations (and overestimate how well pricier stocks will do) or 2) apply higher discount rates to the cash flows of stocks trading at lower valuations as compensation for risk.

Both effects likely contributed to the historical success of value investing. Given the difficulty of forecasting long-term cash flows, it's easy to understand how investors might extrapolate their near-term expectations too far into the future.

However, it's a good bet that mispricing will be less pronounced going forward than in the past, as markets have become increasingly competitive and information more widely available. These improvements should reduce systematic pricing errors arising from behavioral biases.

That doesn't mean value investing is dead. There will likely always be some mispricing, though there's no risk-free way to exploit it. However, the payoff to value stocks will probably behave more like a risk premium going forward.

Risk
The risk of value investing is real, as the past 13 years have shown. Look no further than the coronavirus-driven sell-off. From Feb. 19 through March 24, 2020, the Russell 3000 Value Index lost 32.2%, 7 percentage points more than its growth counterpart. Value stocks tend to have weaker fundamentals than growth stocks. They are less likely to enjoy durable competitive advantages and tend to be less profitable with less favorable outlooks. They also tend to have more fixed assets, which can make them less flexible and potentially more susceptible to recessions.

Hertz is a good case in point. This car rental company is a small-value stock that recently filed for bankruptcy protection, as its vast fleet of cars sat unused when travel largely dried up during the pandemic. While diversified portfolios of value stocks have little exposure to firm-specific risk, some risks are common across most value stocks and cannot be fully diversified away. So, it's reasonable that investors would require compensation for holding this risk.

Why Has Value Underperformed?
If the case for owning value stocks hasn't fundamentally changed, why has it underperformed for so long? The chief reason is that they've gotten cheaper relative to growth stocks, as Exhibit 1 shows. It's possible that change is justified by widening spreads in future cash flows between value and growth stocks. However, this may also be a sign that investors have become overly pessimistic about value stocks. Either way, the valuation gap can't grow indefinitely, so this headwind should subside at some point.

Portfolio Construction and Size Matter
While there are strong theoretical underpinnings for value investing, traditional broad large-value index funds probably aren't the best way to take advantage of the value effect. Small-value stocks are the better bet, as they tend to carry greater risk for which investors require compensation and are more susceptible to mispricing.

Consider the Russell 1000 Value Index, which targets stocks representing the cheaper and slower-growing half of the U.S. large-cap market. From its inception at the end of 1978 through April 2020, this index slightly lagged its growth counterpart by 13 basis points annualized. During that span, the Russell 2000 Value Index, which applies the same construction rules to the U.S. small-cap market, beat its growth counterpart by 2.3 percentage points annualized. Exhibit 2 shows the relative wealth of an investment in each value index compared with its corresponding growth index.

Vanguard Small-Cap Value ETF (VBR), which has a Morningstar Analyst Rating of Gold, is one of the best options for exposure to small-value stocks, especially because it's one of the cheapest. It targets stocks representing the cheaper half of the small-cap market and weights them by market cap, but it starts from a better parent index and takes greater steps to mitigate unnecessary turnover.

Value investing can still work in large-cap stocks, but portfolio construction choices matter. The metrics that index providers use to define value and growth may seem like an important differentiator. Yet differences in metrics across index providers don't appear to make a big difference, as standard valuation metrics tend to be highly correlated. What moves the needle more is whether the index uses a sector-relative approach to stock selection and how aggressively it pursues value.

Most of the return benefit from owning value stocks appears to have come from intrasector stock selection (3). Looking at valuations within each sector should facilitate cleaner comparisons and mitigate persistent sector biases that are a source of active risk that the market may not reward.

The MSCI USA Enhanced Value Index demonstrates how a sector-relative approach to value investing can help. (Silver-rated iShares Edge MSCI USA Value Factor ETF (VLUE) tracks this index.) From its inception at the end of November 1997 through April 2020, this sector-neutral index beat the standard MSCI USA Value Index by 2.3 percentage points annualized. While it had greater exposure to growth-oriented sectors like technology, the MSCI USA Enhanced Value Index tended to have a more pronounced value tilt than the MSCI USA Value Index, owing to its narrower portfolio and use of valuations to size positions.

Value investing hasn't lost its luster, but it's necessary to be patient and selective about how you invest in value stocks. While value will likely make a comeback, it's hard to know when. Diversification is always a good idea. It's best to use value alongside other factor strategies, like momentum and quality, to reduce the pain of underperformance when it inevitably comes.

References
1) Israel, R., Laursen, K., & Richardson, S. 2020. "Is (Systematic) Value Investing Dead?" AQR Capital Management. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3554267

2) Maloney, T., & Moskowitz, T. 2020. "Value and Interest Rates: Are Rates to Blame for Value's Torments?" AQR Capital Management. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3608155

3) Bryan, A., & McCullough, A. 2017. "The Impact of Industry Tilts on Factor Performance." Morningstar. https://www.morningstar.com/content/dam/marketing/shared/pdfs/Research/The_Impact_of_Industry_Tilts_on_Factor_Performance.pdf

 

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