Is value investing dead?
In order to make any sense at all of our complex world, we divide things into all kinds of categories based on common characteristics. The same applies in the world of investment. Investors distinguish between different sectors, countries, small and large listed companies, value and growth stocks, and so on.
Sometimes, this categorization yields useful and beneficial insights; sometimes it doesn't. And sometimes a change in our environment causes a categorization that has long been useful and beneficial to lose its value.
For decades, the distinction between value and growth stocks was highly valuable. Value stocks, usually defined as shares with a low price-to-book valuation, generated substantially higher long-term returns than growth stocks with a high price-to-book valuation.
The difference was so great and statistically significant that the value characteristic was considered a systematic factor for determining long-term returns.
But since the global financial crisis of 2008/09 and, in fact, slightly before that, growth stocks have been doing much better than their value counterparts. Particularly in the last few years, a chasm has opened between the returns of value and growth stocks – to the benefit of the latter category.
This long period of value underperformance has seriously damaged confidence in the validity of the value factor. So, isn't it about time we concluded that value investing is dead?
If we look at the above graph, in which a rising line indicates value stock outperformance and a falling one growth stock outperformance, we can see that value strategies have more frequently shown long periods of extreme underperformance in the past. This was the case in both the 1930s and the 1990s.
Yet every occurrence was followed by a spectacular comeback. Therefore, it’s too early to write off value stocks. On the other hand, we should definitely not rule out that the change in circumstances this time around is so great that value stocks have indeed permanently lost their ability to generate outperformance.
A growing problem is, for example, that the book value - the traditional workhorse of value strategies - is becoming less representative of the value of modern companies’ production resources. Increasingly, these comprise intangible assets such as licenses, copyrights, patents, trademarks, brand names and customer data - which, unlike factories and machines, are difficult to quantify in traditional book values.
Another potential problem is that in the past, value strategies have delivered their best performance in times of high economic growth and rising prices. In other words, when growth was not scarce. In periods of low economic growth and inflation – such as the 1930s, the period since the global financial crisis, and economic recessions – growth stocks usually did much better.
The past century, especially the second half, was a period of exceptional economic growth. There was a sixfold increase in the world's population and yet the average per capita income across the globe grew significantly. If, as various economists expect, we are heading towards a period of lower but historically more normal economic growth, investors may remain charmed by growth stocks for much longer.
That demonstrates that what we are dealing with is a case of tea leaf reading. Neither a miraculous recovery nor a final curtain can be ruled out. And this is the sore spot of the financial profession: we are very good at finding, testing and extrapolating correlations from the past, but not overly successful at devising robust, theoretical explanations for why and exactly under which conditions these correlations occur.
Basically, forecasting with some degree of precision is still beyond our reach. Investing is still more of an art than a science.
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