Is Value Investing Dead?

August 11, 2017

Is Value Investing Dead?

  • The last 10 years have been terrible for value investors as it has seemed like fundamentals don’t matter at all anymore.
  • There are limited options to be a value investor as the Russell 1000 value index has a price to book ratio above 2.
  • I’ll discuss three options for what a value investor can do and the historical results of such approaches.

Introduction

If you’re a value investor or have been invested in a value fund, you probably aren’t the happiest investor in the world right now.

Value funds have been underperforming other stocks in the last 10 years.


Figure 1: The Russell 1000 Value index is up just 43% since August 2007, compared to the 111% for the growth index. Source: Wall Street Journal.

With such underperformance, many have crossed value investing off their lists and look at it as an obsolete strategy used by book worms like Benjamin Graham in the last century. In today’s article, I’ll analyze if there is hope for value investors or if it’s better to jump on the bandwagon of information technology growth stocks.


Value Investing

The essence of value investing is buying stocks at less than their intrinsic values. What do you do as a value investor? You look for dollar bills that sell for 80 cents or even less.

In a market where the average price to book value is 3.23, it’s very difficult to be a value investor as there aren’t many buying options.


Figure 2: S&P 500 price to book value. Source: Multpl.

The market is so far from its fundamentals that even the Russel 1000 value index has a price to book value of 2.02 and a price to earnings ratio of 18.18, that’s not even 4 points lower that the S&P 500 with 21.93 (iShares data used and they do not calculate negative earnings in their averages). As not even the Russel 1000 value index falls under the definition of value investing, is it even possible to be a value investor in this environment?

On top of the above, stock prices are so high in relation to their fundamentals and the divergence keeps increasing. The Cyclically adjusted price to earnings ratio (CAPE) has now passed its 1929 level.


Figure 3: CAPE ratio for the S&P 500. Source: Multpl.

The fact that the CAPE ratio was 15 in 2009 and is now above 30 shows that stock prices have increased twice as fast as corporate fundamentals. The price to revenue ratio has also been growing constantly.


Figure 4: S&P 500 Price to revenue ratio. Source: Hussman Funds.

As the stock market has appreciated even faster than revenue growth, we can clearly state that stock prices are completely detached from fundamentals. Thus, there isn’t much a value investor can do.

Is All Hope Lost?

A value investor has three options: look for value across the world, follow the herd and just buy the top S&P 500 stocks, or stay in cash.

Following the herd might not be such a smart idea as historical market corrections that followed similar market valuations have always been extremely negative with corrections between 25% and 50%, and there haven’t been smaller corrections from such a high valuation level.


Figure 5: Market corrections from current valuations – in percentage of decline. Source: BMI Research.

So if you haven’t turned into a growth investor in the past few years, it would be a terrible idea to do so now. But what the above figure also shows is that staying in cash isn’t such a bad idea as many stocks will experience significant declines and become actual value stocks after the next correction.

For those of you who are sitting on large amounts of cash, the fact that Warren Buffett is sitting on $100 billion with Berkshire Hathaway (NYSE: BRK.A, BRK.B) might make you feel much better.


Figure 6: Berkshire’s cash pile. Source: Bloomberg.

If Buffett is waiting for opportunities to fall into his fishing net, it might be a good idea to follow.

If you are concerned about underperforming as a value investor, Seth Klarman’s 1990s performance should help with that. Seth Klarman significantly underperformed the S&P 500 7 years in a row at the end of the 1990s only to be considered one of the best investors out there now.


Figure 7: Baupost Group performance in the 1990s. Source: Baupost Group Lettters.

If Klarman’s performance hasn’t alleviated your concern, then I’m sure that Nobel prize winning research might help. Fama and French research shows that value investing has beaten growth in both bull and bear markets since 1926, so what’s a decade of underperformance during a bull market compared to 90 years of scientifically analyzed data?


Figure 8: Value investing has outperformed growth investing both in bull and bear markets in the past. Source: Bloomberg.

Conclusion

It’s normal for Wall Street to be always attracted by the latest investing fads. In the 1990s, the mania was about dot-com stocks. In the 1980s, it was all about corporate takeovers. In the 1970s, oil stocks. In the 1960s, the Nifty Fifty stocks, while in the 1700s, it was all about the South Sea Company. Each and every time, value investing was questioned and described as an obsolete way to invest given that the world had changed.

Nevertheless, somehow value investors always emerge with the best long running track records that pass the test of time and cyclical influences. Whether you are a value investor or not, you might want to rethink your portfolio exposure in order to achieve satisfying returns for a set degree of risk. Being currently invested in the S&P 500 means that you run the risk of a 50% decline for single digit returns over the next few years.

Keep reading Investiv Daily as we continuously analyze markets and investment strategies in order to find those that will give the best risk adjusted returns.