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The value cycle

Stock market mispricings don't disappear for good, but come and go. This offers hope for value investors
The value cycle

In the early 1980s, economists pointed out that smaller stocks had outperformed larger ones for decades. That inspired investors to pile into them and into the new small-cap funds set up to meet that demand. Such big buying, however, pushed up smaller stocks’ prices too far – so much so that in 1998 Paul Marsh and Elroy Dimson, two economists at the London Business School, pointed out in a paper entitled 'Murphy’s law' that the small-cap premium had disappeared. But then Murphy’s law asserted itself in another way, and small-caps beat bigger ones in the following five years.

I mention this because it offers hope for income investors. Perhaps higher-yielding stocks will follow a similar trajectory. Certainly, there have been parallels so far.

In 1997, Nobel laureate Eugene Fama pointed out that value stocks had beaten growth stocks over the long term, just as economists in the early 1980s had pointed to small-caps’ outperformance. This discovery, allied to the bursting of the tech bubble, led to value stocks doing well, just as small-caps did in the years after the discovery of their historic performance. Such a good run, however, led to value becoming overpriced just as small-caps did in the late 1980s: in the past 15 years total returns on the FTSE 350 high-yield index have been four percentage points a year worse than those on the low-yield index (this pattern is not confined to the UK. Adam Zaremba at Montpelier Business School and colleagues point out in the latest issue of the Journal of Banking and Finance that value investing has stopped working in most developed markets in the last 15 years).

Which raises the question. Might the analogy between value stocks and small-caps continue to hold? Could value stocks do what small-caps did after 1998, and recover soon after academic research had declared their outperformance to be over?

The issue here is a profound one about how we think about financial markets. On one view, an efficient market – one in which prices embody all available information – is an equilibrium state, which we approach as investors learn from their previous errors. If this is the case, then the value premium has disappeared for good, except insofar as it is a reward for taking on extra risk – which it might well be in the case of cyclical stocks such as housebuilders.

There is empirical evidence for such a view. In the US, David McLean and Jeffrey Pontiff have pointed out that market inefficiencies generally have diminished in recent years – a finding corroborated in the UK by John Cotter and Niall McGeever.

The story of small-caps, however, suggests that this view might not be correct. Rather than market efficiency being a steady state, it’s possible that mispricings and subsequent underperformance and outperformance come and go and come again.

There’s a reason why this can happen, pointed out in a classic paper in 1980 by Sanford Grossman and Joe Stiglitz. If prices are to embody all information, they said, people must invest time and money in researching shares and buying underpriced ones. But they’ll only do this if such investments are profitable. Which means markets cannot be fully efficient: some shares must beat the market to reward information-gatherers for their efforts. There is, they wrote, “an equilibrium degree of disequilibrium”.

But there can be oscillations around this degree of disequilibrium. As the profits to (say) value investing disappear, so too will value investors themselves. Eventually, with fewer people researching and buying value stocks, they’ll become underpriced again, thus offering good returns. In turn, though, these good returns will attract people back into value investing, pushing prices up too much.

And so we get a value cycle, with them outperforming and then underperforming and so on. As MIT’s Andrew Lo has shown, investment strategies will “wax and wane”.

We’ve seen this with small-caps. They waxed in the 1980s, waned in the 1990s, waxed again in the early 2000s, waned from 2007 to 2012 and have waxed, albeit slightly, since. We’ve seen it too with defensive stocks. These did well from 2005 to 2009, then waned until 2011, then waxed until 2017, then waned until 2019, since when they have waxed again.

 

Such cycles give us hope that value stocks will follow a similar pattern and wax again.

Or will they? Personally, I think it’s daft to speak of value investing as a single activity as it lumps together two very different types of shares: mature ex-growth ones such as tobacco and utilities; and cyclicals such as housebuilders and miners.

You can make a case for each of these types doing well. Cyclicals will outperform if hopes of a post-pandemic boom continue to increase. And ex-growth stocks might do well because defensives usually do (except when the market snaps back suddenly) and because investors aren’t very good at identifying what is and what isn’t a growth stock.

These are plausible stories. My point, however, is that ideas such as 'value investing' and 'market efficiency' can sometimes be a hindrance to thinking rather than a help.