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Is a renaissance for value investing in prospect?

28th May, 2020

Published in the Sunday Times on May 31st 2020

Are there sunlit uplands for Value Investors?

After the second world war, Melanesian islanders formed cargo cults near abandoned airfields and performed various ritualistic acts. They thought that if they carried out the rituals they had observed the troops performing at the American air force bases, planes would land and bring them material wealth, particularly highly desirable Western goods. They would therefore march up and down in improvised uniforms performing parade ground drills with wooden rifles.  

I only mention this as a useful point of comparison with today’s long-suffering value investors.

An isolated tribe, going through the formal motions of something they think will bring riches, failing to understand that their approach is redundant and vestigial.

I really don’t mean this last part about the value approach being outmoded and useless. However value investors must feel a bit like Melanesian islanders, where a plane hasn’t been spotted, never mind landed, for well over a decade.

What is value investing?

Value investing is an approach defined as buying companies that trade at low prices relative to their intrinsic value — or its more folksy description of buying a dollar for 50 cents. Historically this approach has delivered a return premium relative to investing in growth stocks, loosely described as rapidly growing companies with rising valuations. Or to continue the metaphor, growth investing is like buying 50 cents for a dollar in the expectation that the 50c becomes 5 dollars. This is a gross over-simplification, but the simple issue currently is that value investing hasn’t worked for over a decade. The return premium seems to have disappeared.

Over the last ten years (to 14th May 2020), the Russell 3000 Value Index has compounded at 6.4%, while the Russell 3000 Growth index has compounded at 12.4%, leading to a 6% annualized spread in performance in US Dollar terms. And 2020 hasn’t provided any reprieve. Value is down just under 25%, against a mere 3% loss for growth (in US Dollars as at May 14th).

Why has value been out of favour?

There’s no single reason for why value investing has had such a bad run though there are plenty of culprits. The finger has been pointed at everything from interest rates to index funds to antitrust regulation.

The interest rate environment has certainly had a part to play, but I think the most compelling reason cited for the poor run in value lies in the changes to market structure over the last decade. Large swathes of the stock market are elusive to measurement based upon traditional valuation metrics.

Traditional measures of value, particularly the much-maligned price-to-book metric (this compares a firm's market capitalisation to the total amount a company would be worth if it liquidated its assets and paid back all its liabilities), seem particularly poorly adapted to deal with today’s market structure. Technology, which is such a large part of stock market today, defies valuation on some of these traditional metrics. An analysis of book value doesn’t capture intangible things like intellectual property and brands. When you have a business with zero capital requirements in high-growth markets, it is the holy grail of investing.

That’s why an encrypted messaging service that doesn’t advertise, doesn’t charge its customers and whose technology  could be replicated relatively easily was able to convince Facebook to pay $19bn for it after only five years in existence (WhatsApp was set up in 2009 and was bought by Facebook for about $19bn (€17bn) five years later.) It’s also why a gamer on YouTube with a half million followers has greater earnings potential than an Ivy League MBA on Wall Street.

To say that corporate valuation has changed is an understatement. This structural change poses a real challenge for systematic approaches to value investing. The focus on mere cheapness has ironically proven costly.

Being wrong is a pre-condition for the value premium

Long fallow periods for the value style have been described as a pre-condition for it to work. This characteristic seems entrenched in its most ardent adherents, like Charlie Munger or Seth Klarman, for whom being wrong is almost a badge of honour.

Value investing is an approach that is drawn to the more toxic parts of the spectrum of public companies. Think about bricks and mortar retail or energy stocks and if you don’t recoil with at least some degree of distain, you should check your pulse.

But therein lies, at least in part, the secret-sauce of value investing. Under-loved means under-owned and under-owned means under-priced. Unless human nature has changed, which has always been a career limiting bet in investment markets, then there will always be toxic looking dollars lying around for 50 cents.

The chasm between value and growth is at an all-time extreme

Many argue that current valuations indicate that the strategy is on the cusp of a comeback. Cliff Asness of AQR says the chasm today between cheap and expensive, is so extreme, it is unmatched in over fifty years of data (Source: Is Systematic Value Investing Dead, AQR, May 8th 2020).

The renaissance in value may already be here — only time and hindsight will allow us to judge. But as persuasive as I find the narrative around why it may be going the way of the postage stamp, on balance I’m drawn to the conclusion that this time is not different. Like almost every question in finance, you can’t say for certain, but I believe there are sunlit uplands for value investors, just don’t press me to put a timeframe on that.

The cargo cults worshiped spirits that never existed. The history of value investing is too rich and strong to dismiss quite as easily.

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