The objective of this article is to assess whether the current socio-economic crisis created an opportunity for value investors to outperform growth ones in the mid to long run. In the past 10 years, large value stocks compounded at 8.7% while large growth stocks compounded at 15% (6.4% annualized spread). As we can see in the table below, taken out from The Irrelevant Investor article, value outperformed growth only in the 20 years’ time frame. That has a lot to do with the dotcom bubble and how value stocks reacted to that event. Nevertheless, iconic investors like Warren Buffet and Charlie Munger have successfully used this way of investing for decades.
The first important thing is to distinguish value investing from growth investing. The latter basically means finding emerging companies with expected growth rates above its industry, sector or market. As a logical consequence, those companies will potentially generate higher returns. In value investing, you assess the fundamentals of the company. You are looking for good, solid and established businesses, the strategy is to buy when they are undervalued. A value stock is defined as one that is trading at a low price relative to the value of a company’s assets, the strength of its earnings or steadiness of its cash flows. “Buying cheap stocks is great, but buying good companies cheaply is even better. That’s a potent combination.” – Joel Greenblatt. We can argue that what drives the prices of such companies down is some kind of inverse momentum but the fundamentals persist.
Given that, periods where value stocks aren’t performing well are almost intrinsic and necessary to the concept of value investing. That’s the time to buy them. Therefore, value stocks are expected to generate alpha to value investing portfolios in the aftermath of a crisis, for example. The question is for how long one has to wait and if the hypothesis of a recovery after a crisis is plausible.
Regarding the latter, it is normal that prices will eventually rise. Value stocks can experience long fallow periods, like the 1960s, when investors fell in love with the fast-growing, modern companies like Xerox, IBM and Eastman Kodak or in the late 1990s the dotcom boom. Nevertheless, the common denominatoris that each time, they have roared back and rewarded investors that never left the boat.
However, this strategy and its results need to be compared with the existing alternatives. As we can seein the chart above value stocks are not responding to the coronavirus crisis as well as the broader market and growth stocks. The impact was more severe and the recovery (which has not finished yet) has been worse. There are some possible explanations for the lack of performance in value investing stocks.
William Bernstein wrote in the early 2000’s, that “investors overestimate the magnitude and persistence of earnings increases for growth stocks, thereby overpricing them, and underpricing value stocks.” It is at least an observation worthy to think about. Probably, the problem of value underperformance is not that intrinsic to the stocks but it has to do with the concept and bias of the ones applying those approaches, the almighty investors.
For most value investors, the underperformance also comes due to a mix of the changing investment and economic environment. “Quantitative” investors have become important players, the algorithms are perceived as a creator of distortion of market dynamics, probably associated to human behavior.
Some traditional value metrics, like price-to-book-value are becoming obsolete since intelectual property, brands and other intangible assets are very difficult to be measured or found in the balance sheet. With the gradual shift from the industry to the services sector throughout the past century, where technology plays a decisive role, this kind of assets changed also the way a company must be valued. Once upon a time, tangible assets easily represented the actual value the firm possessed and were also easier to measure.
Even if value investors have to adapt and evolve their strategy, the core principles remain the same, finding good businesses at an undervalued price. According to an AQR paper, even after adjusting for all the common theories for why value investing has struggled, value stocks are historically cheap.
I would argue that with the March hit, we can find good bargains across several sectors that aren’t going to disappear. Even in those that struggle more, there will always be the winners. In an environment where the majority of the companies incurred in excessive indebtedness, I believe debt should be a metric to look for when searching for a company to invest. Established companies with stronger balance sheets, that operate in sectors hit by the worldwide quarantine but that with some ease can resume their operations and come back to the former level of sales in a short time horizon can still generate good alpha.
The future cannot be predicted and one cannot be sure if value will still underperform or outperform growth, but as Bob Wyckoff argues, “asking whether value is still relevant is like asking whether Shakespeare is still relevant. It’s all about human nature.”
Article published in our May Newsletter
Guilherme Corga, MSc in Finance