Value investing’s crisis of confidence
May 11, 2020
A value approach to investing has yielded great benefits in the past. Though there are often semantics around what constitutes value investing, it can be described as buying securities that are cheap using some metric in hope of outperformance.
Beyond value, investment managers may also choose to work in the small-cap space, buying companies below a certain size in hopes of outperformance. Historically, small-cap stocks have displayed a significant return premium.
So why not go ahead and buy small-cap stocks that are also value stocks and reap profits? Indeed, many investment managers have used this exact strategy, though their results in recent years leave much to be desired.
Using the Russell 2000 value index as a proxy, small-cap value stocks in the U.S. have yielded negative total returns over the five years ending March 31, 2020. Large-cap growth stocks, viewed by many as the counterpart of small-cap value, have lagged small-cap value stocks on a long-term historical basis. However, over the 10 years ending March 31, 2020 the S&P 500 large-cap growth index trounced small-cap value stocks, with a 227 per cent total return versus a relatively paltry 95 per cent return for the Russell 2000 value index.
This long-term period of pitiful relative performance for small-cap value stocks has been enough to cause a crisis in confidence among investors, many claiming the death of the return premium for small-cap value investing. And institutional investors, who often have sizable allocations to value, small cap, or combined approaches within their equity mandates have a lot at stake in determining whether this is actually the case.
A historic opportunity in small-cap value investing?
Looking at small-cap value equities from a buy low, sell high perspective shows that we are at a potentially historical level of attractiveness for this cohort of stocks. A report by O’Shaughnessy Asset Management compared the earnings yield of the cheapest small-cap stocks to the most expensive large cap stocks using this metric. The spread between the two was at a level only seen 1.7 per cent of the time throughout history, with earnings yields on small-cap value stocks a massive 21 per cent higher than expensive large-cap stocks. Further, the research showed that from previous levels this extreme, small-cap value stocks had outperformed their expensive large cap counterparts over the next 10 years by 16.8 per cent per year. In dollar terms, a $1 million investment into small-cap value stocks at historical points like the present would have yielded an additional $3.72 million dollars over 10 years versus an identical investment in expensive large-cap stocks.
The question for investors then becomes, is this historical performance and historically extreme dislocation enough to dive in?
Sir John Templeton is credited with having said the four most dangerous words in investing are ‘this time it’s different.’ The recent sustained outperformance of large-cap growth stocks in the U.S. has undoubtedly caused some money managers to ask whether this time is truly different and whether the premium earned by value investing is a thing of the past.
Experts have weighed in, attempting to provide reasons for why value investing may no longer work, or alternatively, why it’s likely to recover. A common critique of current value approaches, specifically those based on price-to-book multiples, is that these approaches fail to account for the value of intangible assets, which incorrectly biases the metric against growth companies that are often technology-based and widely hold large amounts of intangible assets.
Others have found this critique wanting, showing that the pronounced recent outperformance of growth relative to value wasn’t fundamental in nature, but almost entirely due to multiple expansion, as investors have increasingly placed a premium on the earnings of growth companies, but the growth companies themselves haven’t fundamentally become more attractive.
Another potential explanation for value’s sustained difficulty could be interest rates. A concept that’s useful for understanding this thesis is equity duration. That is, value stocks tend to have shorter duration than growth stocks, as more of their economic value is expected to be derived from cash flows in the near-term, whereas much of the value of growth companies is expected to accrue to the investor deep into the future. In an oversimplified example, consider a value stock as being a very high coupon five-year bond, and a counterpart growth stock being a very low coupon five-year bond. As rates move lower (just as they have drastically in recent years) the low coupon bond, which has higher duration, will outperform significantly.
Beyond these arguments, the sector composition of these two styles may help explain recent returns. For instance, sixty-five per cent of the S&P 500 large cap growth index is in thematic sectors of the new economy such as information technology, consumer discretionary and communication services, whereas the Russell 2000 value index’s largest allocations are in more challenged cyclical industries such as financials and industrials.
A leap of faith
Positioning an equity portfolio with either a value or growth bent requires some measure of faith.
But for those who don’t want to rely on faith alone, a few measures institutional investors can take to improve outcomes include not putting all of their eggs in one basket and diversifying across different approaches within a style. An example of this would be not simply investing using a classic price-to-book factor, but also with other historically robust factors such as enterprise value to earnings before interest, taxes, depreciation, and amortization or price to earnings.
Additionally, a style diversification approach can be prudent. Many consultants and asset managers will suggest an approach that includes both growth and value styles, which will help an institutional portfolio not be overexposed to potential long stretches of underperformance for a style like we’ve seen with value.
Lastly, and importantly, institutions will likely see better long-term results when they’ve clearly established a reason for going down a certain path, such as value investing. If the reasons for undertaking the strategy are clearly understood by those charged with oversight, the risk of abandoning the strategy at the worst moment can be mitigated.