There has been a lot of talk about the death of value investing.
The strategy, embraced by Benjamin Graham and Warren Buffett and many followers, has beaten the market over decades going back to the 1930s, but it's hard to ignore how badly it has fallen behind in this recent 10-year period, eclipsed by the high-growth technology sector.
Still, value investors persist. They undoubtedly find support from like-minded investors. It’s human nature to have a set of core beliefs, flock to others who also believe them and to embrace information that supports those beliefs.
For investors, though, there's a danger of succumbing to confirmation bias. It's important to be able to step back and judge an investment strategy objectively, and see the other side of the argument. Here are five arguments why the value strategy might not work as well in the future as it has in the past.
1. Value is a bet against technology
Unconstrained value strategies tend to gravitate to certain sectors over others. This can vary, but most strategies tend to underweight technology stocks. A sector-neutral approach could reduce some of this risk, but for unconstrained value models, this is a drag on performance.
Over the past decade, underplaying tech stocks has been costly. Value strategies have emphasized sectors that have done relatively poorly, such as financials. Technology stocks, meanwhile, have led the market and continue to do so.
Of course, this can work both ways. Value investors in 2000 were probably happy they were underweight technology stocks when the dust settled on the dot-com bust. But if a new normal has been created and more people believe tech stocks will drive the market going forward, that's a bad sign for value.
2. Big Data are leading to more value traps
The more data that are available and the faster they can be processed, the more efficient the market should become. That could mean that more cheap stocks are cheap for a reason. It could also mean that using historical fundamental information to predict the future will be harder.
Let’s say a value investor picks Walmart Inc. shares because they trade at a discount to the market based on several traditional fundamental measures. But other investors have different data that could explain why Walmart shares are cheap and destined to remain that way. They might have access to satellite images of Walmart parking lots demonstrating low customer flow. Or they might have credit-card data that show sales are declining.
For the traditional value investor, information gaps could be masking value traps.
3. The world is different
It's not just access to additional data that has challenged the traditional concept of value investing. There is a different approach to risk taking.
The U.S. Federal Reserve and other central banks changed the rules a decade ago through a massive quantitative easing, including large-scale asset purchases and risk-taking without consideration for fundamentals.
In that type of world, things such as value and quality may not matter. At the very least, they may matter less and endure longer periods when they don’t work.
4. Too many people are doing it
Despite the strategy’s underperformance, there have been a proliferation of factor-based funds that use value measurements, and there are large investment firms such as Dimensional Fund Advisors that have put a lot of capital to work in value strategies. Perhaps these investors believe the markets will revert to the mean, as they have in the past.
But in investing, whenever there's a stampede into a strategy, the less effective the strategy becomes. It has the potential to degrade or eliminate the value premium.
5. The capital following it is becoming more permanent
A greater understanding of the role of behaviour in financial decisions is helping investors to develop stronger wills when it comes to their strategies.
It is counterintuitive in some ways to think like this, but followers of value strategies want other value investors to panic and sell during periods of underperformance. That bad behaviour is in part what makes the strategy work. Permanent followers of the strategy who won’t panic no matter how long it underperforms can reduce its effectiveness over time.
In presenting these five arguments, I’m not suggesting the value strategy will never work again. The case against value investing has just as many valid counterarguments. But it’s easy to get caught up in a feedback loop that only supports your case. Instead, consider the other side of your thesis and the arguments against yours. This process will make you a better investor over the long run.
If you are a value investor in need of diversifying with some growth stocks, or are just looking for growing companies in general with good fundamentals, here are five stocks from Validea.com and five from Validea.ca that score highest based on one or many growth models we run.
John Reese is chief executive officer of Validea.com and Validea Capital, the manager of an actively managed ETF. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock screen service.
John Reese