Everyone knows about value investing now, and everyone is tilting towards value, so its going to stop working. Everyone is saying this to me lately-sometimes as a question, sometimes as a statement of fact.
Yogi Berra famously said, “no one goes to that restaurant anymore, its too popular.” Is the same thing happening to value?
The most common definition of value, courtesy of Fama/French, is book/price. But book/price has many limitations. It is not as effective as a combination of other factors which work better in large cap (B/P works best in illiquid small/micro cap). We prefer a composite factor (equally weighted calculation using s/p, e/p, ebitda/ev, fcf/ev and shareholder yield).
Here are the rolling 10-year excess returns (versus an equally weighted benchmark) for two value factors: book/price and the value composite. You can see that 1) the composite is vastly superior to B/P alone and 2) the very simple trend lines are moving in opposite directions.
I don’t read a ton into the declining B/P trend line. I think that value works because it exploits behavioral issues in the market and because so few investors can stick with it. Case in point, a book to price value investor has underperformed for the last 10 years. I still think even B/P will work in the future. But the data from the value composite debunks this idea that value is dead.
/rating_on.png "1 Star")
/rating_off.png "5 Stars")
Loading...
Value works because it tells you to invest in companies which the market thinks are terrible.
A case in point. Lehman reported OK quarterly numbers before it crashed in 2008.
The price took a nose dive, but its book remained static.
Lehman is the bullet left in the chamber in a game of Russian roulette.
Ironically, that’s why value still works. You’re continuously playing Russian roulette, not many people enjoy that!
The composite trendline suggests value is below trend and thus attractive? But does the composite’s value spread support this view?
Spreads don’t look great, although they’ve widened a bit here very recently. I am not 100% sure of the value spreads have as a signal or factor timing tool. They are certainly useful at extremes (in hindsight only, no way of knowing the extreme at the time), but I don’t think they are hugely helpful in more "normal" markets. It is an area I intend to devote a lot more time to in the future.
Value exists because it makes its practitioners feel virtuous. It has a much higher moral tone than those vulgar momentum chasers. It fits into the fable of the Ant and the Grasshopper. The fact that masochism is also part of value investing is another moral plus, sort of like a hair shirt.
However Ben Graham was quite open that his partner, Gerry Newman, a growth stock investor, was the one who made all the money for the firm.
My personal supposition is that book value increasingly fails to capture ‘value’ as it did in the past when asset heavy businesses dominated the market. I bet the gap between the average earnings yield on cheap book/price stocks vs. the market has widened over the last few decades. Book value has lost traction as a measure of value since so many businesses today are capital light (tech, biotech, pharma, consumer services etc) so even when these sorts of businesses are out of favour they don’t look cheap vs capital heavy businesses on bk/p. Too many people blindly accept F&F’s view that all valuation metrics are just scaling mechanisms and p/bk is best due to lower turnover, without questioning if the world had changed. It’s still ok for financials but far less effective for non financials in my view. Do you agree?