Don’t write the obituary for value investing just yet.
The investing style remains deeply unpopular, having lagged the performance of growth stocks for years. But that doesn’t mean it should be overlooked, according to a white paper by O’Shaughnessy Asset Management.
Value stocks are shares of companies that are cheaper than their peers relative to earnings or other metrics. Value investors buy them, anticipating they will make up the gap. But for years, they have lagged behind the broader market as well as growth stocks, which are shares of companies whose earnings are expected to grow at an above-average rate.
Since the financial crisis bottomed out in March 2009, the broad large-cap S&P 500
has outperformed the S&P 500 Value Index by 3 percentage points. The S&P 500 Growth Index has outperformed value by 7 percentage points in the same period, according to FactSet.
In an effort to figure out why value has underperformed for so long, O’Shaughnessy Asset Management’s team of researchers deconstructed the returns and found that value’s weakness stemmed from the financial crisis.
In the wide-ranging paper, they took a look at value portfolios formed in each month from December 1963 to October 2016 and then followed their performance over the subsequent one-year holding period, plotting their realized excess total returns versus returns for the equal-weighted market.
They found that the 10-year future yields of value portfolios ended up coming in below the future yields of the market in virtually all 10-year periods that overlapped with the crisis.
The bottom line is that beaten-down companies didn’t bounce back like investors had come to expect.
“The financial crisis had a crushing effect on the earnings of value stocks. Fundamental earnings recovery of these businesses simply did not happen,” said Patrick O’Shaughnessy, chief executive officer at O’Shaughnessy Asset Management, in an interview.
“Indeed, in 2008-09 it was financials and energy that became cheap but they never rebounded. In the case of energy stocks, oil prices plunged by more than 50% twice since then. These value stocks were cheap for a very good reason,” O’Shaughnessy said.
Another explanation might have to do with the phenomenon of hyper-profitable “new economy” companies like Facebook Inc.
and Alphabet Inc.
the authors said.
“Statistically, these companies aren’t as likely to end up in value portfolios as ‘old economy’ companies such as those from the energy, material, industrial, financial and retail sectors, groups that have obviously had a much a harder time,” the paper said.
Outside of the financial crisis, O’Shaughnessy and his team found that value stocks do indeed rebound, mostly because their prices are driven too low by investors dumping them in droves and creating a bigger-than-justified discount.
This discount normally should be about 60% of the regular market valuation, but the cheapest 20% of the stocks are sold at roughly half that price, the report said.
But eventually, most value companies improve their earnings prospects and investors reward them for that, usually bidding up prices much faster than earnings actually improve, leading to a rise in the price-to-earnings ratio.
The excess return, or the outperformance, from the value strategy, therefore, comes not from buying cheap stocks and holding them long-term but by capturing the short-term bounce.
Portfolios that employ a “pure value” strategy, investing in the cheapest 20% of the S&P 500 and rebalancing once a year, therefore have a high turnover, nearly 38% a year, according to the paper, with the excess return coming from this churn. Such a turnover is a feature, not a bug, of this strategy.
This is why deep value strategies are often highly concentrated bets in certain sectors and, by design, are more volatile than the market.
Value investors, however, would only benefit from holding such a portfolio for years if not decades, as the value factor is cyclical and at times will underperform the market.
O’Shaughnessy cautions investors not to try to time the value factor.
“Our research shows us that value factor is very cyclical, but these cycles do not fall into neat patterns and no two markets are the same,” said O’Shaughnessy.
Still, O’Shaughnessy and his team think this is a good time to for investors to have exposure to value stocks, precisely because the strategy itself may be, well, undervalued after years of underperformance.
“Would you rather buy a strategy that has done really well over the past 10 years or really badly? Compared with the market, value is really cheap,” he said.