Value investing has been the most consistent way to outperform the market for decades. It continues to work because it forces you to buy stocks for which the market has very low expectations (expectations which often turn out to be overly pessimistic). People are overly sensitive to losses and often shun value stocks. But what about using value in a sector that has traditionally been the most expensive out there? As we shall see, it is possible to find diamonds in the rough.
One of the interesting byproducts of value investing has been a chronic underweight to the most fun sector: information technology. Let’s say every year all you did was buy the cheapest 10% of the market based on measures of value like price-to-sales, price-to-earnings, and EBITDA-to-enterprise value. The chart below shows—through time—what sectors you would have owned in this simple value strategy. Notice the slim band for IT stocks (in highlighter yellow). It is no coincidence that the sector has been the worst performing through time: technology companies—especially new ones—are often exciting, but you have to pay a dear price for stocks with vivid and potentially game-changing futures.
Consider technology stocks by one common value metric: price-to-cash flow. Below is the historical ratio for technology stocks versus the rest of the market (all non-tech, non-financial stocks).
What had been a massive overvaluation relative to the market has been steadily shrinking since the peak of the NASDAQ bubble in 2000. This lines up with the widening of the yellow band in Figure 1.
One great feature of value investing is that it doesn’t hold grudges. Who cares if tech has been expensive and a weak performer for decades? If those stocks are now trading at much cheaper multiples, we should consider them for the portfolio. I’ve written about Apple’s transformation from growth darling to hated value stock back to value darling. Apple’s journey typifies the sector as a whole.
Buying the best technology stocks
While more and more technology stocks look cheap, you can also use value to select the best investments within the technology sector. In fact, over the long term, the cheapest technology stocks have done quite well even as the most expensive tech stocks have lost money.
Here is the universe of technology stocks broken into quintiles (and best & worst 25 stock portfolios), and their historical returns and standard deviation of returns. These results are based on a rolling, annual rebalance like my other tests. Cheap technology stocks have delivered an annual return of nearly 14.5%, and have done so with much lower volatility than the rest of the sector.
We know that value works across sectors, but these results highlight the importance of valuations within sectors as well. If you want to buy tech stocks, forego the new exciting ones and focus instead on the cheap, seasoned alternatives.
Value and More
Value only works if you stick with it and adapt to changing opportunities. There are other factors—like momentum, quality, and shareholder orientation—that have provided an edge just as value has through time. I combine several of those key ideas into a cohesive whole in my upcoming book, Millennial Money: How Young Investors Can Build a Fortune. For information on the extra content available to those who pre-order the book, you can read more here.