The value conundrum

Once a very popular and successful strategy, value investing is now on a decade-long losing run. Many are losing faith despite its recent rally on news by Pfizer/BioNtech and Moderna about effective and safe Covid-19 vaccines. Is value simply going through a rough patch, has it permanently lost its edge, or are we just looking at it all wrong? 


As a reminder – what is value investing? At its core, it is the simple principle of buying stocks that appear cheap on measures of fundamental company value, such as earnings or assets, and selling those that appear expensive. The theory suggests that good businesses can become undervalued as investors tend to overreact to negative news, and strong returns can be made when this temporary distortion between the price of the stock and its intrinsic (true) value eventually corrects. The strategy was popularized in the 1930s by David Dodd and Benjamin Graham, whose disciples include – amongst others – Warren Buffett.


Of these measures of fundamentals, book value is perhaps the most frequently cited when assessing a value investment opportunity. Book value is a measure of a company’s net assets as reflected in its accounts; by comparing book value (per share) with a company’s share price, investors can get a picture of how a company’s stockmarket value is diverging from its balance sheet assets. Because these accounting values are relatively stable relative to share prices, which fluctuate daily for a variety of reasons, many value investors believe they provide a good way of measuring increases or decreases in a company’s long-term value. In this scenario, short-term share price volatility could therefore present opportunities to invest in companies whose assets are mispriced.


By contrast, a growth investor might believe that current or historic measures of company fundamentals are not the best way of assessing what they will be worth in future. An ‘old economy’ company in terminal decline would look misleadingly cheap based on value metrics whereas a fast-growing technology company could look very expensive. For this reason, growth investors will rely more heavily on future estimates of fundamental factors such as earnings.


There are many more investment styles and complexities than just value versus growth, and the discussion around which method is best is decades old. Value investing has certainly accumulated a lot of enthusiasts over the years and there is a wide body of academic research attesting to its historical efficacy as an investment strategy.  


One of the most popular studies produced was by Nobel prize winning professors Eugene Fama and Kenneth French. In 1992, they founded the “three factor model” which they used to explain excess returns in a portfolio compared to the market. Among these three factors is an HML (high-minus-low) factor, which is referred to as the “value premium”. They found that, historically, those stocks with a high book value compared to the market average generated a premium investment return. 

Value investing was a successful strategy for decades, generating consistent superior returns, but during the last decade this has not been the case. At the beginning of 2020, Fama and French published an update of their analysis on the value premium. They studied the returns of the US stockmarket between 1963 and 2019 and found that value stocks had produced higher average returns. However, the value premium fell sharply in the second half of the period (1991-2019): to 0.11% from 0.42% in the first half of the review period. 


To illustrate value’s recent poor run, the following chart displays the performance of the MSCI World Value Index relative to the MSCI World Index. Since the 2008 financial crisis, value has significantly underperformed the market, and this trend has intensified during the Covid-19 crisis.


The value conundrum


By some measures [1], value is currently suffering its largest drawdown in two centuries. In contrast, growth stocks have had an extremely strong run, epitomized by the share price performance of the FAANG group of tech companies, which has seen the likes of Apple, Amazon, Google and others reach trillion dollar status.


This divergence in fortunes for value and growth over the last decade has seen the valuation gap between the two widen to levels not seen since the 2000 tech bubble.


The value conundrum


Many investors have claimed that such a wide gap in valuations is unsustainable, and a bounce back in value is inevitable. Conversely, others have argued that value as an investment strategy is now structurally impaired and will not regain the historic performance premium it once had.


One possible explanation for value’s underperformance since the global financial crisis is the ensuing era of ultra-low interest rates. When assessing share prices, interest rates are investors’ key element in deciding how much future earnings are worth to them now. When interest rates are high, future earnings are worth less in today’s money as they are discounted back at a higher rate. Equally, when they are low, as they are now, future earnings are hardly discounted at all when calculating how much you would pay for them now. This favours growth companies relative to value companies as a high portion of their worth relates to how they are expected to grow in the future.


Is this a temporary factor in value’s underperformance or a structural headwind? The answer to that depends on whether you expect interest rates to revert to more normal levels at some point or if we are indeed already at a ‘new normal’ of very low rates for the long term.


Another possible explanation for value’s underperformance – and one that is structural in nature – is technological change that may have rendered value investing obsolete. This theory suggests that value investing may have worked for the capital-intensive, asset-heavy industries such as manufacturing or bricks-and-mortar businesses that dominated in the 20th Century but is less relevant for the service-based and high-tech sectors that make up the modern economy.


Could this mean that the traditional measures of value are obsolete? Specifically, could book value now be a poor determinant of a company’s asset base given the modern importance of intangible assets? Intangible assets such as brand value, intellectual property and human capital are a much greater focus for companies’ investment, as displayed in the below chart from Style Analytics. These intangible assets are difficult to value and are often not reflected in a company’s book value.


The value conundrum


If we were to adjust the price-to-book measure to account for these intangible assets, then those companies investing heavily in R&D, branding and patents would appear cheaper. As shown in the below chart by Research Affiliates’ Leadbetter, Li and Linnainmaa (2020), this adjustment to reflect companies’ true asset bases would have the greatest impact on those companies that are considered growth.


The value conundrum


This analysis potentially calls into question whether the traditional growth and value labels are helpful or risk mischaracterising companies with lots of intangibles as low-asset (and low-value) stocks. The researchers also adjusted price-to-book values to include R&D expenditure for the 10 US stocks which have the greatest difference between their R&D spend and book value. This method significantly altered some stocks’ valuation profile. For example, IBM went from trading at a 90% premium to the large-cap average when measured on a traditional price-to-book value basis to a 1% discount when R&D was added into the book value.


A separate Research Affiliates study(Arnott, 2020) undertook a similar experiment by adjusting Fama & French’s HML factor to include intangibles (iHML). As the chart below shows, value’s performance vs growth between December 2006 and December 2016 is much better using the iHML measure rather than HML.


The value conundrum


Although the last few years have seen a significant underperformance of value compared to growth using both measures, the researchers explained that, going forward, incorporating intangibles into measures of value should protect the structural value return.


Maybe this modified approach to measuring assets should be a source of optimism for proponents of value investing. Perhaps it suggests that the style’s underperformance has been far less concerning than some breakdowns would suggest. Or is it possible that the modern economy is changing in a way that makes this traditional value/growth framework more of a hindrance than a help in understanding modern companies?


It’s not clear what the answer is and, given that the debate is almost 100 years old, perhaps we shouldn’t expect one any time soon.

[1] Value Investing: Even deeper history, Mikhail Samonov, Two Centuries Investments

Liontrust Insights


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Wednesday, November 18, 2020, 3:03 PM