Is value investing dead? The financial media has long proclaimed its demise, backed by strong outperformance of growth stocks compared to value stocks. The numbers are clear: over the past decade, growth stocks have produced a 17.4% annualized return, vastly higher than the 10.6% returns from value stocks.
Further illustrating the gap, an investor starting with $100 and focusing only on growth stocks would have earned almost $400, more than doubling the $173 earned by the value investor over this period. So, what has happened to value investing?
Value Investing: A Lost Decade
At its core, value investing focuses on paying a bargain price for an asset. We believe that there is a widespread misperception about what value investing is, that value investing is not dead and is increasingly likely to emerge as a successful strategy.
First, index providers including FTSE Russell, which is the source of the above-mentioned returns, use an outdated definition of value investing. According to their definition, value stocks are those with low price/book value multiples. This purely statistical method has diminished relevance in a world where company value is driven by intellectual assets (which aren’t recorded by accountants the same way as a factory or other hard assets). Nor is it meaningful when book value is reduced by aggressive borrowing and share repurchases.
Further, low-multiple definitions ignore the growing secular risk from the digital revolution underway, in which nearly all businesses must adapt or fail. In many cases, low-multiple stocks reflect secular losers that will fail, not undervalued bargains.
Also, value investing itself has evolved. In the late 19th and early 20th century, when public equity markets were rife with schemes, frauds and near-zero corporate transparency, and traders like Jesse Livermore, immortalized in the 1923 classic Reminiscences of a Stock Operator, made profits using momentum and ticker-tape watching. Investing based on fundamental analysis and valuation, pioneered by Benjamin Graham and outlined in his 1934 investing bible Security Analysis, offered a way to sort through the jumble to find quality companies that could survive and prosper – often available at bargain prices in a market that had neither the patience nor the skill to find them.
In the decades following the Second World War, as disclosure, management practices and investor sophistication improved, value investing evolved toward buying quality companies at prices temporarily beaten down by recessions or temporary dislocations like the 1963 Salad Oil swindle. Legendary value investor Warren Buffett prospered in this period, shifting from the “cigar butt” approach to “great companies at good prices.”
Today, value investing involves the same basics – paying a bargain price for an asset. It involves understanding the intrinsic value of companies, including the effect of secular change regardless of industry or capital base, and seeking to buy them at bargain prices. Value investing includes bargains produced by temporary dislocations and cyclical downturns but certainly isn’t limited to these traditional definitions.
The value vs growth debate has another element: time. In the post-war period, recessions and booms were frequent, arriving every 3-7 years. This produced growth/value cycles of about the same duration. However, since the 1982 recession (almost 40 years ago), economic growth cycles have lasted about a decade. This provides fewer bargain-producing opportunities and gives true growth companies a longer runway to increase their earnings – and see unfettered gains in their stock prices.
Aiding this cyclical extension is the Federal Reserve Bank. Starting with the 1987 market crash, the Fed began shifting its policy from inducing recessions to mitigating them. No longer removing the punch bowl, the Fed is now spiking it. The effect on value investing: prolonging investor enthusiasm for growth stocks at the expense of traditional value stocks.
Growth and value cycle lengths have expanded with the economic cycle lengths. Growth investing performed well in the 1990s, ending with the Dot-com bubble. Value investing produced much stronger returns in the 2000-2010 decade (+3.64% annualized rate compared to a ‑2.25% annualized loss for growth). The past decade, of course, has been a growth cycle.
With the digitization of the economy being accelerated due to the COVID-19 pandemic, investors have accelerated their valuation assumptions in response, rivaling the run-up at the end of the Dot-com era. Perhaps the growth style of investing has reached its limit.
Value investing is about finding companies with enduring value, at bargain prices.
Which kind of an investor are you - growth or value? Or both? Which kinds of stocks have been your best performers of late?
*This post has been updated from an original version, published in 2020.