Is value investing dead? This question has come up from time to time for years – but more so than ever over the past few years. This is no doubt due to the fact that value investing has now underperformed growth investing over the past 1, 3, 10 and 30 years. In this post we consider whether or not value investing will once again outperform growth investing, as well as the implications for investors.
- Growth vs. value investing
- Why has value investing underperformed?
- What would cause value investing to outperform once again?
- Does the definition of value investing matter?
- The future of value investing
Historical and recent returns – Growth vs. value investing
Up until the last decade or so, the common wisdom was that value portfolios always outperformed over the long term. It was however accepted that growth portfolios sometimes outperformed over the medium term. The following chart from The Irrelevant Investor illustrates the difference in ten year returns from 1936 to 2017. What matters on this chart is whether or not the line is above or below zero, rather than the direction of the line.
As you can see, before 1993 there were very few periods where growth outperformed. From 1993 to 2000 growth portfolios outperformed, but the outperformance quickly reversed when the Dotcom bubble burst. The outperformance returned after 2008 and has continued through 2020. The result is that growth funds have now outperformed over a 30-year period for the first time.
According to Morningstar, the gap between the performance of growth and value investing has never been as wide as it was at the end of 2020. Over the course of 2020 large cap value strategies underperformed by 32% while small and mid-cap value underperformed by even more. The following chart compares the performance of the Vanguard World Growth and Value funds since 2008. It clearly illustrates how persistant the outperfromance has been.
Why has value investing underperformed?
Stocks that are considered value stocks typically belong to mature companies. While the “value” of a stock may increase over time, the price when it is initially purchased should be at, or preferably below, its fair value. By contrast, growth stocks belong to companies that are growing. In many cases growth companies are not even profitable. Investors earn returns because the value of the stock increases as earnings increase.
A stock can generate a return for an investor provided the companies earnings grow over time, even when the initial price paid is at a substantial premium to fair value. The last few decades have been more favorable for growth investing for several reasons. The following factors are the most prominent reasons for this:
- Technology and the internet
- Interest rates and inflation
- Democratization of investing
Technology and the internet
Since 1990 we have seen completely different types of growth stocks emerge. Most of the leading growth stocks belong to companies that leverage the internet to scale their businesses very quickly across exceptionally large markets. Before the internet emerged, growth companies tended to belong to manufacturing and retail industries. While these companies operated in large and growing markets, they were still capital intensive. To fund growth, they had to take on debt or issue new shares. Both alternatives would ultimately affect the attractiveness of their shares.
By contrast, internet and software businesses require little capital to grow. Once a product has been built, the marginal costs of producing and selling each additional unit is very low. Scaling these businesses doesn’t require additional staff, machinery, warehouses, or raw materials. Internet businesses do require additional computing power and data storage as they grow – but the cost of these resources falls each year.
This phenomenon is even more apparent with companies like Google and Facebook. These are essentially media businesses that don’t need to pay for content. By contrast, traditional media businesses must pay to develop content, and then pay to distribute that content. Furthermore, Google and Facebook have an additional advantage because they are able to offer advertisers exposure to very narrowly defined target audiences.
There are some exceptions. Growth companies like Amazon, Apple and Tesla do need to invest in additional employees, factories, warehouses, and machinery. However, these companies are the exception – and they have also been able to leverage low interest rates and high stock prices to fund growth.
Interest rates and inflation
Tech businesses have also created a positive feedback loop with regards to inflation and interest rates. Increased efficiency and the scalable nature of industries like ecommerce, cloud computing and SaaS platforms have helped to keep a lid on inflation. This has allowed central banks to reduce interest rates to historically low levels for an extended period. The lower cost of capital has boosted innovation and consumer spending, both of which benefit growing companies. At the same time, with few signs of inflation, risk appetite has remained high.
In many cases, technology growth companies have also disrupted existing industries. This means the legacy companies in these industries are struggling to compete and facing an existential crisis. This phenomenon is best illustrated in the retail industry. Ecommerce platforms, led by Amazon, have decimated the business models of more traditional retailers.
A growing list of longstanding retailers like J.C. Penney and Sears have either faced bankruptcy or been forced to downsize. In these instances, stocks that appear to be attractively valued are in fact value traps. Not only have these value traps resulted in lower returns for value investors, but they have made investors skeptical about other stocks trading on low valuations.
Economies and businesses have become increasingly globalized over the past few decades. At the same time, rapid economic growth in Asia and in particular China has resulted in a growing global consumer market. Furthermore, technology now allows businesses to reach this growing global market cheaply.
The result is that the addressable market for media, software and similar businesses is much larger than ever before. Where traditional broadcast media networks were limited to certain countries, a company like Netflix can now target anyone in the world with a stable internet connection. The growing global market means more stocks can realistically become multibaggers . So, stocks trading on high price multiples can still generate decent returns – which has made growth stocks even more attractive to investors.
Democratization of investing
Another factor to consider is the type of investors active in the market, and the way they behave. Technology has made investing and sophisticated trading tools accessible to more people. Platforms like Robinhood that make investing extremely easy have popularized investing amongst a new generation of investors. These investors can also use leverage, especially when interest rates are low.
For these investors, momentum strategies are a lot more practical than value investing. Momentum is more closely tied to growth stocks than to value investing which is a more contrarian approach. Capital from new investors is far more likely to flow to growth stocks than value stocks. The performance of value stocks is still broadly in line with the long-term performance of the stock market. It’s just that growth stocks have been a lot more attractive over the past few decades.
What would cause value investing to outperform once again?
With so many factors driving the outperformance of growth stocks it may seem that value stocks are destined to continue underperforming. However, the situation could actually change quite quickly if the environment changes. These are some of the catalysts that could lead to a rotation back into value funds:
- A slowdown in digital economy growth – The majority of growth stocks are connected to the digital economy. And a lot of these stocks are trading on extremely high price multiples. If there is any sign that these companies are struggling to maintain their revenue growth rates, a shift into value stocks would probably occur. It’s very unlikely that the digital economy is anywhere close to reaching maturity. However, a pause in growth is quite likely in the next few years.
- Growth stocks struggle to find a route to profitability – Many of the top performing stocks of the last few years are still not profitable. Some companies are also spending a lot on marketing. It remains to be seen whether or not these companies can reduce their marketing spend and still turn a profit. If profitability becomes unlikely for a lot of growth companies, investors will need to become more selective. This may result in a short-term shift to value, but ultimately it would benefit the growth companies that can turn a profit.
- Rising interest rates – If interest rates rise, the opportunity cost for investors will rise. This may cause significant deleveraging, in which case investors would become more selective. Value and profitability would then become more important than growth. The deflationary forces currently at play do not appear to be temporary. So, any increase in inflation an interest rates would probably be temporary.
- An extended period of market volatility – Risk appetite has been remarkably high for the last decade. This is partly because there have been few periods of volatility that have lasted more than a month or two. If this changes, investors would become more risk averse and valuations would matter again.
These catalysts are more likely to lead to a short-term shift back into value stocks rather than a return to long term outperformance. The digital economy has a long way to go, so the environment is likely to favor growth stocks for at least the next decade. When it comes to the longer term, value investors will probably need to adapt to the changing environment to generate decent returns.
Does the definition of value investing matter?
The definition of growth investing is fairly straightforward. Growth investors buy shares of companies that are growing their revenue and earnings. Investor’s earn returns because a company’s profits grow over time, resulting in the value of the company increasing and the stock price rising.
Defining value investing is a little more complicated. It’s generally accepted that value investors buy stocks that they believe are trading at a discount to their “value”. The terms fair value, intrinsic value and book value are all used when referring to value. Regardless of the term, value means different things to different people. Value can refer to a company’s equity value, liquidation value or to the present value of future cash flows.
Over the years there have been at least three distinct approaches to value investing.
- Benjamin Graham approach – Benjamin Graham, regarded by many as the father of value investing, liked to buy stocks trading well below what he thought they were worth. When Graham referred to intrinsic value, he was talking about the liquidation value of a company – in other words the value of its assets after all debts had been repaid. This approach is all about a company’s balance sheet, rather than its future earnings potential. With this approach the worst outcome is that the company is liquidated, and investors receive the liquidation value. This approach was highly effective when Graham applied it during the 1930s and 1940s when a lot of companies were indeed trading at deep discounts to their equity value.
- Warren Buffett approach – While Graham bought fair companies at great prices, Buffett has been more inclined to buy great companies at fair prices. Buffet considers a company’s competitive position and profitability, as well as the price he pays for it. With many of his best investments Buffett has made far more from the company’s ability to compound its earnings than it has from the initial discount. Nevertheless, buying stocks at a discount does give him a margin of safety until the company’s value begins to increase. These days, most active value investors follow a similar approach. Typically, they will use the discounted cash flow (DCF) model to work out the present value of expected future cashflows to arrive at a fair value. This approach entails subjective analysis to estimate future cash flows – so there is still some uncertainty.
- Quantitative approach – Over the past few decades, quantitative investing has grown in popularity for several reasons that we outlined previously. Quantitative value funds use valuation metrics based on historical data to select stocks. The advantage of this approach is that strategies can be tested against historical data. The disadvantage is that these strategies are backward looking and don’t take changes in the economy and environment into account. Where active value funds tend to use qualitative analysis, passive value funds, including ETFs, are based on quantitative strategies. Although these approaches are quite different, returns have been similar for both active and passive value funds.
The future of value investing
Value investing has evolved in the past, and it’s likely it will have to evolve again. In particular the question of what constitutes value needs to be reconsidered. Valuation ratios that were appropriate when assessing manufacturing businesses in the 1960s are not necessarily appropriate for today’s software companies. A particularly good example of this is the price-to-book ratio which is commonly used by value investors.
This ratio uses the book value of a company which only considers its tangible assets. So, the price-to-book ratio of Alphabet ignores the value of all Google’s algorithms, patents and even its brand. These intangibles are actually Alphabet’s most valuable assets. Value investors may also need to consider the metrics that venture capital investors use when assessing tech investments. These include the customer lifetime value, the churn rate, and the size of the total addressable market.
Other characteristics that should be considered are a company’s competitive advantages and ability to attract talent. Obviously, these metrics are appropriate for technology companies but not necessarily for companies in other industries. One of the biggest challenges value investors will face will be determining the relative value of businesses in different industries. This is where technology may help.
In the future many of the funds that outperform are likely to be those that leverage new technologies like artificial intelligence and big data. Lehner Investments uses these technologies to measure sentiment and other data points when selecting stocks for the Data Intelligence Funds. In the future it’s likely that value fund managers will make use of technology as well as alternative data sets, to get a better idea of what really leads to value creation.
Conclusion: Is value investing dead?
The real lesson here is that investors should know what they are buying and avoid relying on individual metrics or “rules of thumb”. Value investing is contrarian and assumes a “reversion to the mean” – but when the environment changes and mean reversion takes place can take a very long time. What do you think? Is value investing dead?