The theory behind the value investing style is very straightforward. You buy stocks that are undervalued and then hold them until the market recognizes the inherent value and bids the share higher. Many of the most famous investors of all-time are known for their adherence to the value investing style. This group includes the likes of Benjamin Graham, John Templeton, Bill Miller, and of course, Warren Buffett. An extra twist to this method, as practiced by famed value investor Mario Gabelli, is to buy value stocks that have a catalyst. Gabelli and his team of analysts look for undervalued companies that have an upcoming potential event that will get the market to notice them.
Historically, value has outperformed growth, vindicating the chosen investment style of the aforementioned titans of finance. However, the last 11 years have been quite a different story as growth has far outpaced value.
What are the reasons for value’s long streak of underperformance?
Well, if we look back at the last decade, we can start with the Great Recession and the Federal Reserve’s actions during the recovery. First, the Fed lowered rates to near zero which effectively neutered one of the tenants of value investing: choose companies with a strong balance sheet. With companies able to raise debt at historically low rates, those that chose not to lever their balance sheets were penalized by investors. Companies that did lever up with cheap debt were able to invest in growth opportunities, both through organic expansion and acquisitions. The same thing can be said for investing in companies with a solid cash flow profile. Historically, value investors flocked to companies with a steady stream of cash flows, but again this attribute became diminished in the eyes of the market.
The second problem was the Fed’s quantitative easing (i.e. flooding the market with cash), which caused investors to be much less discerning with their money. During the last decade, a lot of money has been chasing a finite number of investments, causing investors to stop worrying over valuation. If you don’t believe me, take a look at the valuation of a high flyer like Tesla or Netflix.
So maybe the problem is we’ve had a really long interest rate cycle?
Possibly, and both of the aforementioned problems are winding down as the Fed is raising rates and is no longer growing its balance sheet. Let’s not forget to mention that since 1928, value has outperformed growth every time rates have risen.
Related to the extended interest rate cycle is that financials has been the worst performing sector over the last decade, and unfortunately for value investors it is the sector with the largest weighting in value indices. Look at the top holdings of any large cap value fund and you will see some combination of JP Morgan, Wells Fargo, Citibank, and Bank of America. The third largest sector in most value indices is energy, and until recently, it had performed poorly for years. Financials and energy combine for a stunning 43% of the Russell 1000 Value Index. Technology, on the other hand, only accounts for 9% of the value index, but it is a third of the growth index.
Has value investing relinquished its throne or do we perhaps need to re-evaluate how we define it?
In 1992, Nobel Laureate Eugene Fama, who is commonly known as the ‘father of modern finance,’ and fellow professor Kenneth French created the Three-Factor Model which predicts that value stocks outperform growth stocks.
One of the key ratios used by Fama and French to discriminate between value and growth stocks is the Price-to-Book ratio (P/B). In this ratio, ‘price’ is simply the market value of the company, while ‘book’ is the assets minus liabilities. A low P/B ratio has historically been treated as an indicator of an undervalued company, but is that still true? The methodology used to select the constituents of the Russell 1000 Value Index is heavily weighted towards low P/B ratios. This is why the index is stuffed with financial companies and why it also overweighs old economy industrial companies that own many physical assets. Conversely, technology companies mostly get ignored, as they typically do not have many assets. A great example of this problem is Apple. The maker of the iPhone appears to be a value stock based on profitability, cash flow and balance sheet, among other metrics, but because of its relatively high P/B, it falls into the growth index. Warren Buffett would seem to agree that Apple is a value stock since he recently made it the largest holding at Berkshire Hathaway.
Perhaps value hasn’t really underperformed as badly as we had thought. Maybe we need to evolve our understanding of value investing just as Warren Buffett has.
Column by Charles Castillo, Senior Portfolio Manager at Beta Capital Wealth Management, Crèdit Andorrà Financial Group Research.
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