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Value Investors Are Vexed

Value isn't dead, it's just been dormant.

A version of this article appeared in the March 2019 issue of Morningstar ETFInvestor. Download a complimentary copy of Morningstar ETFInvestor by visiting the website.

The concept of value investing dates back at least as far as the 1920s, when Benjamin Graham and David Dodd first began teaching finance at Columbia University. The fundamental principles of value investing were later enshrined in the duo’s classic “Security Analysis,” first published in 1934.[1] The idea is painfully simple: Buy securities at prices below their intrinsic value and wait patiently for their market price to reflect their true worth. Or as my grandfather used to tell me, “Investing is simple, buy ‘em cheap and sell ‘em dear. Did I mention that it’s not easy? Good luck!”

The approach, so elegant in its simplicity, ultimately evolved into a religion of sorts. Many of Graham and Dodd’s disciples, most notably Warren Buffett, rank among the most successful investors of all time. However, despite having basic intuition and legions of followers on their side, it wasn’t until 1992 that Graham and Dodd’s theory gained a rigorous empirical backbone. That was the year Eugene Fama and Kenneth French published their seminal work, The Cross-Section of Expected Stock Returns,”[2] which introduced the concept of the value premium. The pair found that stocks trading at low price/book multiples tended to outperform those trading at high multiples over long time horizons. Fama and French showed that value was real, it was significant, and it could generate excess returns. However, their version of value was hatched in academia, a realm free of pesky issues like fees, trading costs, and taxes--real-world problems that might affect investors looking to harness the value premium.

Value “style” indexes were ultimately born out of these ideas. These indexes were at first designed to be style-appropriate benchmarks for active managers, and it was only later that they were adopted by index funds and exchange-traded funds. Their performance can give us a sense of the real-world value premium available to investors. From Dec. 29, 1978,[3] through Feb. 28, 2019, the Russell 3000 Value Index gained 11.97% on an annualized basis, while the Russell 3000 Growth Index grew by 11.20% annualized. This 0.77% annual value “premium,” compounded over decades, netted a substantial increase in ending wealth. A $10,000 investment in the value index grew to $937,759.17 as of the end of February. The same $10,000 invested in the growth index yielded $711,476.79--a 32% difference. Clearly, Graham and Dodd were onto something.

Value Has Fallen Behind 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 against 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 February 2019, the Russell 3000 Growth Index has outperformed its value counterpart by nearly 4 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."[4]

And It's Been Falling Out of Favor In fact, there is evidence that some value investors have been capitulating after years of watching growth outperform. Exhibit 2 plots trailing 12-month flows of investor capital into and out of value and growth mutual funds and ETFs, across large-, mid-, and small-cap stocks dating back to the beginning of 1994. At 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. And while there was a brief reversal that likely owed to value's short-lived postelection rebound in 2016, investor sentiment appears to have more recently soured again.

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 to come.

This is how it might play 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 likely 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.

The Value Menu There are a host of ETFs that look to home in on value. The plain-vanilla ones track broad, market-cap-weighted benchmarks that tilt toward value stocks by splitting their parent indexes into growth and value halves. Others look to more cleanly isolate the value premium by focusing on stocks that demonstrate the strongest value characteristics. Exhibit 3 contains data for the 10 largest value-centric U.S. large-cap equity ETFs on the menu today.

There are differences among these apparently similar funds that are important to understand. First, each fund’s benchmark index may have different value measures that it takes into consideration. For example, in the case of iShares Russell 1000 Value IWD, the fund’s benchmark relies on stocks’ price/book ratios as its lone value metric. iShares S&P 500 Value IVE tracks an index that uses price/earnings, price/book, and price/sales ratios as value factors. These differences can affect performance, though one set of metrics often isn’t clearly better than another. What matters more is how pronounced the portfolio’s value tilt is and whether there are any other bets that come with it, like persistent sector overweightings.

It is also critical to understand how these funds’ bogies weight their underlying constituents. For example, IWD’s benchmark weights its members by market cap. Invesco S&P 500 Pure Value ETF RPV weights its holdings on the basis of the strength of their value characteristics. Weighting holdings by market cap may dilute the portfolio’s exposure to the value premium and reduce tracking error relative to a broad-market index. Cap-weighted value indexes will give the greatest weightings to the biggest value stocks, which aren’t necessarily the cheapest. Using other measures to weight constituents will likely increase tracking error and might introduce unintended exposures to other risk premiums.

Even more important than the nitty-gritty details of index construction is investors’ fortitude. Some of these funds might be easier to stick with than others. For example, RPV had the best absolute returns over the trailing 10 years ended Feb. 28, 2019, among the nine funds in Exhibit 3 that were around 10 years ago--by a wide margin. It also outstripped the Russell 3000 Growth Index during that span. But that was a bumpy ride. The fund is substantially more volatile than its peers. So on a risk-adjusted basis, the fund tends to rank near the bottom of the pack. While a fund like RPV might provide more-potent exposure to the value factor and the potential for greater absolute long-run returns, it comes at the cost of greater volatility. The real risk facing investors is that this added volatility can make this strategy tough to stick with.

These characteristics matter when it comes to fund selection. Even after a long drought, value is alive and kicking. But successful value investors have to be able to hold tight in order to reap the long-term rewards that value investing can offer.

[1] Graham, B., & Dodd, D. 1934. “Security Analysis.” (New York: McGraw-Hill)

[2] Fama, E.F., & French, K.R. 1992. “The Cross-Section of Expected Stock Returns.” J. Finance, Vol. 47, No. 2, P. 427.

[3] Note that this predates the July 1, 1995, inception of both the Russell 3000 Value and the Russell 3000 Growth indexes. Performance figures from Dec. 29, 1978, through these benchmarks’ inceptions represent back-tested performance.

[4] Fisher, P. 1958. “Common Stocks and Uncommon Profits.” (New York: HarperCollins).

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