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The demise of value investing may be greatly exaggerated

Here’s an unwanted accolade hoving into view. It won’t be long before value investing sets the record for the longest period of continuous underperformance in the history of equity investing. Currently, this dubious distinction is held by investing in smaller companies. The so-called ‘size effect’ (the performance of small-cap stocks minus that of big ones) logged 16 years of continuous underperformance in 1999. Value investing is just entering its 16th year, having started its decline in 2006.

One intuitive response is to say, ‘how can that be? It’s well-known that value investing has been doing badly, but surely not for that long?’ Fair point, but trends are often identified only with the help of hindsight. Smaller-company investing is a neat example. Even in the early 1990s it remained a universal truth that small-co stocks would always outperform. No one really knew why, not that there was a shortage of explanations. Most of these boiled down to the reasonable notion that small things can grow quicker than big things so this must apply to companies too; or, at least, until it became blindingly obvious it didn’t.

Something similar seems to be happening with value investing. Market data provider MSCI says its underperformance started in 2006. But that is the best part of 10 years before a prolonged bear market for value stocks was widely acknowledged. For most of 2006 to 2016 it was not possible to say which way value investing was going and it wasn’t until 2016 that a pronounced downward lurch set in, a drop that became vertiginous in 2018.

Besides which the prolonged decline of value investing is an assessment that relies on the particularly miserable performance of value stocks in the US. According to MSCI data, US value stocks badly lagged the global average for value in the years 2000-06, marked time with the average for the 10 years to 2016, then fell especially heavily after that. However, this tells us as much about investors’ clamour for technology stocks, which have a strong bias towards the US, as it does about the rejection of value. It wasn’t that value was broken, it just looked that way in comparison with the performance of superstar stocks, the likes of which the investment world had not seen at least since ‘Big Blue’ – IBM (US:IBM) – looked invincible in the 1960s.

Using 2006 as the starting point for the prolonged underperformance is understandable, but it skews the effects. As the chart implies, value stocks had a great time of it in the early years of the century as the investing world’s first encounter with internet-based technology ended in tears. So value’s underperformance began from a very great height.

Meanwhile in the UK, where stock market indices hold more companies that run on the tangible assets favoured by value investors, value hasn’t done so badly. The chart shows the relative performance of MSCI’s indices for UK value and UK growth compared with the underlying MSCI UK index. Not just that, but the value index is MSCI’s ‘enhanced value’ metric, which uses quantitative measures to manoeuvre around stocks that look good value but are actually dross; for instance, it uses forecast earnings for price/earnings multiples and favours cash flow over accounting profits. The upshot is a value index that performs much better than the bog-standard variety.

From a base of 100 on 1 January 2000 for both indices, enhanced value surged to 168 by May 2007, by which time growth had dropped to 91. In the aftermath of the 2008 sub-prime financial crisis, both indices more or less rose together, although value’s moves were erratic. And it wasn’t until mid 2019 that growth finally got ahead of its enhanced value counterpart. Yet these indices also only measure capital values. Factor in the higher dividend yield expected from value stocks and UK value is still probably ahead of growth from a starting point at the turn of the century.

Ahead, but not by much and lagging badly from a starting point around 2007. To the extent that investing is a game of relative performance, that matters. So it would be useful to know why value investing has done so poorly for so long, especially as conventional wisdom says this can’t happen; that, long term, value investing always wins because it focuses on stocks that are serially unfavoured and therefore undervalued.

Obviously, conventional wisdom is being called into question and MSCI’s analysts reckon their relentless focus on quantitative analysis provides an insight. Part of the problem is that there is no such thing as a pure value stock. So when investors buy a value stock they also acquire other investment characteristics that shape investment returns, such as growth, the effects of financial leverage and the idiosyncratic nature of each and every company. Isolating 16 such characteristics – or ‘styles’, as MSCI labels them – can shed light.

The analysts found that ‘price to book’, the archetypal value style where investors buy a stock trading at a low multiple of the accounting value of a company’s net assets, worked especially well in 2001-10, but only decently during 2011-20. Profitability – or lack of it, as is often the case with value stocks – was a minor drag on performance in 2000-10 but became a major negative in 2011-20. Buying stocks on a low price/earnings ratio was a big help in 2001-10although a hindrance in 2011-20. But the two big reversals were in momentum and stock-specific factors.

That momentum helped performance in 2001-10 but hindered it in 2011-20 is almost a statement of the obvious. After all, momentum basically follows the notion that winners continue to win, leaving losers lagging further behind. In 2011-20 it was taking almost a percentage point per annum off value’s returns. Stock-specific factors were a minor irritant in 2001-10, but became a major issue in 2011-20. They cut almost 2.3 per cent a year off value’s performance, which was almost a percentage point worse than the drag imposed by all style factors combined. However, MSCI also points out that even isolating the two key value factors – price to book and low PE ratio – would have generated only ordinary performance overall, with a distinctly worse showing in the second half of the 20-year period. In the real world that would not have been possible anyway because there is a distinction between a granular quantitative analysis of returns to value investing and the messy business of valuing companies, buying shares and building portfolios. If value investing, as the name suggests, is about buying an asset for less than its intrinsic value then that inner worth must somehow be estimated. In practical terms, that demands a range of skills from analysing a company’s accounts, to understanding its markets and putting a present value on its possible future cash flows.

Granted, there is the question whether conventional analysis counts for so much in an era when intangible assets increasingly dominate the tangible kind. Yet intangible assets often sit on a group’s balance sheet too and, where they don’t, they can be implied by capitalising research and development spending (although companies do plenty of that already). For many analysts, adding factors such as these into their bag of tricks is hardly new.

Similarly, many value investors, while hardly enjoying these past few years, have generated returns far better than the value returns shown in the chart. For example, had the performance of the Bearbull Income Portfolio been worked into the chart, its index would have peaked at 319 in mid 2017 and would be 234 now against 102 for the value index and 128 for the growth variant. Maybe that will be as good as it gets, who knows? Maybe value investing will claim that unwelcome accolade. But my guess is that mean reversion isn’t dead even if the economies of scale that power technology titans give that impression; that the notion of buying a pound for less than 100p will continue to generate good payback, especially for those who remember to keep their investing intelligent.

bearbull@ft.com