Why Value Always Wins

Market indicators, not cycles, drive performance.

March 8, 2011

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1339521_stuffed_animalsIn the debate over passive versus active investing, there’s always been one safe bet: value stocks. Well, sorta. Value stocks performed horribly during the 1990s tech run-up. Investors were amply rewarded thereafter. But we’ve had another bearish market for value stocks since the Great Recession.

It seems, as the old saw (often attributed to Lord Keynes) goes that markets can remain irrational longer than wise investors can remain solvent. But, what kind of markets?

That may bear on the value problem. After all, in the long term (a phrase properly attributed to Keynes) there is an outstanding anomaly: value beats growth, and by extension, beats market-cap-weighted  investments, according to the Fama-French model.

Still, as reported earlier, Fama and French have made some revisions to their model, giving it even more of a value bent on the basis of international evidence, across markets as disparate as the U.S., Europe and ever-underperforming Japan. The value factor still appears to win, over time.

However, MSCI Barra researcher David Owyong suggests market regimes may have a role to play, particularly risk aversion, which is presumed to apply in recessions – who wants a beaten-up company in a downbeat economy? His paper, “Value Stocks and the Macro Cycle” examines value stocks with particular – but not exclusive – reference to Asia Pacific companies.

“The major trends of relative Value performance are broadly similar in Asia Pacific and the global universe, and the turning points largely coincide,” he explains. “Broadly speaking, the Value cycle has undergone four phases in the last fifteen years. The first period in the late nineties was one in which Growth stocks and particularly technology stocks performed well, while Value stocks experienced a period of relative decline. After the tech bubble burst in 2000, the rebound of Value stocks began and lasted for five years, until early 2005. From that time, the bull run in the overall stock market accelerated and … the Momentum strategy started to perform much better than Value. The underperformance of Value stocks in this third period culminated in the Quant Meltdown in August 2007, which triggered a rapid decline in the relative performance of Value stocks for about 18 months. The fourth and final period began with the recovery of the overall stock market in March 2009, with Value stocks playing a leading role in the market recovery.”

Those are familiar episodes for long-time market observers. But is it deflated investor exuberance that accounts for the value factor, or something else? Owyong states, quite starkly: “There is no obvious link between the Value Cycle and that of the overall stock market.” So much for diversifying over both value and growth, one might think.

What he arrives at is, first, that value stocks are related to leading indicators – this is the data researchers pore over to determine economic trends. “Whether for the Asia Pacific region or globally … the Value cycle moved in the same direction as macroeconomic expectations, particularly from 2001 onwards. This is in line with the expectation that Value stocks become relatively riskier and thus less attractive during economic downturns, and vice versa.”

That’s the beginning of an explanation, but by no means a complete one. As Owyong notes, “However, there are periods in which this apparent co-movement did not seem to hold. When the Asian crisis began in 1997-98, currency values started to freefall and, despite worsening economic prospects, some governments in the region were forced to raise interest rates to protect their currencies from speculative attacks. The same was true in the second downtrend of the Value cycle from 2005 to 2008. Interest rates were again on the rise during this period, partly due to Federal Reserve interest  hikes that began in 2004. On the other hand, when the Value cycle was trending up during 2000-2004 and after 2008, interest rates were generally declining and were at relatively low levels. In total, these observations are consistent with expectations that the Value cycle tended to move up when interest rates were low.”

Ah yes, cost of capital. Cheap sometimes, dear other times. No wonder value folks emphasize a “margin of safety” or a cash cushion.

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