The Buffett approach - is value investing past it or passed fit?

Another year, another Warren Buffett annual letter to shareholders for readers to feast on. Buffett gets cut an awful lot of slack in terms of performance, but I can’t think of a time when he has been the subject of greater scrutiny than now, given the torrid last decade for performance. I’ve forced myself to consider arguments on the other side of value. And I’m persuaded by many of them.  

Berkshire Hathaway performance

Every Berkshire letter shows the year by year performance of Berkshire Hathaway (Buffett’s investment vehicle) shares relative to the performance of the S&P 500 with dividends included. It’s a remarkable 56-year track record, though not without disappointment. A quick tabulation will show there were nineteen years when Buffett’s return was below that of the market. 

Notwithstanding this, Buffett has managed to almost double the annualised return delivered by the S&P500 from 1965-2020. The US stock market’s 10.2% p.a. return over this 56-year period has delivered a tidy 230 times return on original capital, turning $1,000 in to just over $230,000. Berkshire Hathaway’s return of 20% p.a. does not give you double this return - through the magic of compounding it gives you more than 100 times this return. 

The lesson here is that it’s not the frequency with which you are right that counts, it’s by how much. One of the world’s best long-term investors can deliver disappointment one third of the time, and still come out considerably ahead. The aggregate gain is 2,802,957%, turning $1,000 into a hardly credible $2.8m.

A troubled decade

The last 56 years masks a period of considerable underperformance in the last ten years. Berkshire has underperformed the market by a cumulative 79% since 2011. Much of Buffett’s compounding gain was during the first half of his career. 

This stands to reason. Buffett’s edge fifty years ago, at least in part, arguably doesn’t exist today. Pockets of opportunity existed in the 1970s and 1980s, when technology was cumbersome, access to data was both expensive and scarce. But in today’s world, those informational asymmetries are largely absent, and so are many of the easily exploitable opportunities. Buffett’s style has evolved over the decades – thanks in no small part to Charlie Munger who convinced him to focus on better businesses rather than the ‘Cigar butts’. But unquestionably the value approach has come unstuck. 

Value investing has a great long term record

Over the long term, value investing has been one of the most reliable ways to beat the market. A style promulgated by Buffett and even identified by academics some thirty years ago as a factor that generates a return premium to the market. But for value disciples, it has been a barren thirteen years, save for short bursts of interim performance.  

Value investing at its simplest, holds that stocks which are cheap compared to their book value (or some other sensible measure) will do better over time. It’s even intuitive - “Buying dollars for 50 cents.”

Long fallow periods for the value style is almost a pre-condition for it to work but as Charlie Munger once said “Rapid destruction of your ideas when the time is right is one of the most valuable qualities you can acquire. You must force yourself to consider arguments on the other side.”

The other side of the argument

In consideration of the other side the first point of controversy, is that book value has become an incomplete and limited measure of a firm’s size. With such a large proportion of today’s stock market made up by companies where a growing share of book value is in intangibles — it has rendered the traditional process of uncovering cheap stocks redundant.

In addition, according to analysis conducted by Societe Generale, value stocks tend to do badly relative to the market when the economy is doing badly. And since the financial crisis, economic growth in the US, has at best been tepid.

There is also a correlation between value stocks and the direction of bond yields, which also tend to be driven by the economy. When yields are falling, value does badly, and vice versa. And bond yields have been in decline for a generation, but particularly so during the last decade. So value has been buffeted by both poor economic growth and declining bond yields. 

In fact, value is the only major equity factor that is negatively correlated with 10-year bonds. And herein lies the potential seeds of optimism.

The seeds of optimism

The recent rise in bond yields has set at least part of the trend into reverse – notice how sectors that are under-valued and exhibit sensitivity to higher yields – US financials for example - have rallied strongly. If that trend were to continue and you want to hedge against a bond market decline, value stocks look like a decent way to play it.  

The only thing more dangerous than a view that changes with the weather, is a view that never changes. I’m not wedded to value and it could ultimately go the way of the cassette tape. But recent concerns about its demise are wide of the mark.