Booms and busts in the stock market often create excesses of optimism and pessimism among investors who convince themselves the world has changed forever.
Often, these beliefs are encouraged by gurus who come up with persuasive, headline-grabbing arguments. It’s at times like these that more sober investment professionals warn this time is not different.
A current example is the debate over whether value investing is dead. Value stocks are those that have cheap prices as measured relative to a company’s profits or the value of its assets. They are typically companies in traditional industries such as manufacturing, financial services and resources. By contrast, growth stocks often have relatively expensive prices, based on their above average rates of revenue and/or earnings growth.
For over a decade, U.S. value stocks have substantially underperformed growth stocks, including most notably high-flying tech giants like Facebook, Apple, Netflix and Alphabet, parent company of Google. That’s led some observers to question whether the long-standing outperformance of value stocks has disappeared for good.
It’s an important question because since the 1920s, value stocks have generated better returns than growth stocks. In the U.S. going back to 1926, the probability of value stocks outperforming growth in any 10-year period is 84%. For this reason, we at PWL tilt our clients’ portfolios towards value and small-cap stocks (another category that has generated a return premium over the long term).
Ironically, the return premium for value stocks can be traced to the same excesses of optimism and pessimism that lead to “this time is different” kind of thinking. Investors tend to get too enthusiastic about the prospects for fast-growing companies and overly depressed about slower growing businesses. When reality sets in, the expensive stocks tend to underperform the cheaper ones.
In recent years, that hasn’t happened. Growth stocks have marched steadily higher and value stocks have languished for the most part.
However, a major rally in value stocks over the past couple of months has led to speculation over whether the tide may be finally turning. During October small-cap value stocks outperformed the overall U.S. market +3.4% versus -2.3%, according to PWL’s Market Statistics. That’s a huge five percentage point difference for a single month. Value stocks have continued to perform strongly in November in response to the good news on a COVID vaccine.
The key argument put forward by those who believe the premium for value stocks will not come back is related to the idea that the world has evolved from a manufacturing economy to a knowledge-based one. These observers argue that accounting rules don’t adequately capture this change in valuing companies’ profits or assets.
This paper by Rizova and Saito rebuts this argument by showing why the growing importance of intangible assets—the foundation of the knowledge economy—doesn’t preclude value being measured today as it was in the past. Among other things, the authors observe that investments in intangible assets are nothing new.
This article dispels the myth that the boom in growth stock has been based on the extraordinary performance of a small number of tech giants. Instead, it has been broad-based across all growth stocks, suggesting the real cause is not a new paradigm brought on by revolutionary technology advances.
The article’s author, Cliff Asness, observes that the success of value investing doesn’t depend on getting trends right. Rather, it depends on human nature and the tendency of investors to make expensive stocks too expensive and cheap stocks too cheap.
PWL Capital Research Director Raymond Kerzérho just released his closer look at the value premium in his new paper, The Value Premium: Fact or Fantasy.
Historically, when the value premium returns it comes back very fast and strong—like what we’ve seen in October and November. That was certainly the case after the dot.com bubble burst in the early 2000s. In these cases, investors that have stuck with their value discipline have been paid for their patience.
There’s no way of knowing whether the recent rally in value stocks marks the start of a long period of overperformance. However, we don’t think human nature has changed, and when it comes to value stocks, we don’t think this time is different.