Even the Nobel-winning economists who discovered ‘value’ as a style of investing are puzzled. Tom Bailey explains.
One of the major mysteries of financial markets in recent years has been the supposed death of value investing. Unfortunately, in a research paper published earlier in the year, the two economists and Nobel laureates most credited with proving the “value premium” are also stumped by its disappearance.
The basic idea is that stocks deemed to be “cheap” end up providing greater performance over time than those deemed expensive. There are several ways to measure how “cheap” a stock is, with one of the most popular being the price-to-book value ratio (P/B). Book value factors in all of a company’s assets — such as stocks, bonds, inventory, manufacturing equipment and property (minus debt) — as stated on its balance sheet. On the basis of this, value investors determine the price-to-book by dividing market price per share by book value per share.
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P/B has somewhat fallen out of favour in recent years. One reason for this is the rise in importance of intangible assets (patents, software or branding), the value of which is not easily captured on a balance sheet. As a result, investors now emphasise other metrics of value, such as the price-to-earnings ratio. P/E is determined by dividing a company’s share price by its earnings per share. The figure tells you how much investors are willing to pay per dollar or pound of a company’s earnings, so a lower P/E means that a company is cheaper.
Other metrics can also be used relative to price to establish how cheap a stock is, such as current cash flows, dividends and sales. Whichever way its measured, the general trend historically has been for value stocks to outperform the rest of the market over the longer term, known as the so-called value premium. Many indices that try and track a basket of value stocks often end up using some combination of the various ways to measure value.
The tendency for cheap stocks to perform better was first identified by Benjamin Graham in the 1930s. Since then, however, reams of academic literature have been produced to show more systematically the outperformance of value. Most influential, has been the work of two academics: Eugeme Fama and Kenneth French. One study by the two academics showed that between 1975 and 1995, the average return of a global portfolio of low valuation stocks was 7.68% per year higher than that of a global portfolio of stocks with high valuations. Similar data exists for different periods of time and different specific country markets.
However, in recent years investors have been somewhat perplexed by the seeming disappearance of the value premium, meaning the underperformance, on average, of value stocks. This is usually expressed by comparing an index of value stocks to an equivalent normal, market-cap weighted index or an index of growth stocks. For example, the MSCI All Country World Index has returned 188.9% over the past decade (total return, denominated in sterling). Meanwhile, the MSCI ACWI Value index has returned 116.4%. Blowing both out the water, the MSCI ACWI Growth index has returned 278.2%.
A bigger differential can be seen among just US stocks. The Russell 3000 Index, which measures 3,000 of the largest stocks in the US, has returned 318.3% over the past decade and the Russell 3000 Growth index 458.5%. Meanwhile, the Russell 3000 Value has returned just 202.5%.
This persistent underperformance of value stocks has caused a lot of debate among market commentators and soul searching among struggling value fund managers. Some have proposed that under current economic conditions (low growth, low interest rates and low inflation), value is bound to underperform. Its return, the theory says, will come about only when underlying economic conditions change.
Another popular theory is that the value investing model itself is broken due to the increased importance of intangible assets, as already mentioned. Meanwhile, some have proposed that, like all factors, the value premium has been arbitraged away. This means that the now widespread acceptance that value stocks perform better over the long term has meant investors have bid up the prices of these stocks, save for the truly doomed and therefore appropriately cheap companies.
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With such debate over value investing, it is only natural that Eugene Fama and Kenneth French would step back into the debate with a new paper, revisiting the possible reasons behind the decline in the value premium that they did so much to identify. Their findings were published earlier this year in a new paper appropriately entitled: “The Value Premium”. Unfortunately for investors, the two academics are fairly hesitant about drawing any strong conclusions. Indeed, speaking to the publication Institutional Investor French said: “The short answer is you pretty much can’t say anything.”
What they did find, however, is still useful. In their paper, they compared the monthly return of a value portfolio to that of a market-weighted portfolio (that is, a normal market-cap weighted index). They found that between 1963 to 1991, value stocks in the US market returned 0.42% per month more. Over the next time period, between 1991 and 2019, they found that this premium was just 0.11%, significantly lower than that of the first period.
So, we know that the decline in the value premium has happened. French and Fama, however, are hesitant about formulating any theory to explain this. Citing the high volatility of monthly premiums, they essentially argue that there is no way of telling if poorer returns for value since 1991 are simply by chance.
With that in mind, they also reject the idea that the decline in the value premium since 1991 can be interpreted as meaning value will continue to underperform. They note: “The high volatility of monthly value premiums clouds inferences about whether the declines in average premiums reflect changes in expected premiums.” What this means is that they believe there is no reliable evidence to argue that the poorer performance of value over the past 28 years means that value will continue to perform poorly in subsequent years.
And so, the mystery of the disappearance of the value premium rolls on.
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