Value investing shone in the four decades from the early 1930s until late 1960s (about 37 years).
However, at the end of the period, value investing started to lose its lustre with value stocks beginning to severely underperform.
One reason may be that academics started to publish research demonstrating that markets are informationally efficient. That is, stock prices reflected all publicly available information. What moved prices was unexpected information, and, because of that, no one could anticipate price changes to consistently beat the market. As a result, investors were advised to join the market by investing in index funds and becoming passive as opposed to active (value) investors, which they seemed to have done for the following seven years, ending in the mid-'70s.
Surprisingly enough, and despite the academic research, starting in early 1975 we witnessed the beginning of another golden 37-year period for value stocks, which carried until mid-2012, with very small interruptions. From 2012 until 2019, value stocks underperformed once more, as they had done between 1967 and 1975.
In recent years, as in the late 1960s, pundits started to write the obituary of value investing. But this time it was not just market efficiency that was responsible for the presumed death of value investing. It was possibly 1) technology that destroyed “economic moats”; 2) the growth of intangible investments that made book values irrelevant; 3) low interest rates that made far in the future growth opportunities look high in present value terms; and 4) the popularity of ”smart beta” strategies and factor investing that eliminated underpriced value stocks.
The graph below plots the annualized three-year average monthly “value premium” (i.e., low price-to-book (value) stock returns minus high P/B (growth) stock returns) against a measure of four-year expected inflation (a three-year moving average of inflation data obtained from FRED – Federal Reserve economic data). Examining the two sub-periods in which value investing underperformed supports the argument that the real culprit and the common denominator for such underperformance may have been none else but low inflation (and by extension low interest rates). Indeed, the correlation between a measure of expected inflation and the “value premium” is 50 per cent, which is quite high for such data.
Annualized 3-Year average monthly U.S. value premia to P/B ratio based value and growth strategies: 1966-2019. Source: Meritocracy Capital Partners of Vancouver,The Globe and Mail
But how does low inflation/interest rates affect value stocks? Low interest rates (and low inflation, especially, fears of deflation) hit value stocks the most, while they benefit growth stocks the most.
P/B ratios, for example, are a function of interest rates. As rates converge toward zero, the P/B ratios of all stocks rise significantly above historical levels. In this setting, companies with very low P/B ratios tend to be bad companies and “naively” investing in them by definition leads to underperformance. Additionally, P/B ratios are higher than they appear during periods of deflation for heavy asset companies, such as value companies. Therefore, when calculated P/B ratios look like they are low, in fact they are not, as deflated asset values blow up the true ratio (in replacement terms).
At the same time, P/B ratios are also a function of the growth rate of earnings going forward. Firms for which markets expect low earnings growth tend to have low multiples and vice versa – a relationship derived from the equity valuation model taught at every university around the globe. In fact, markets tend to be overoptimistic about growth for high multiple firms and overly pessimistic about growth for low multiple firms. Growth stocks’ optimistic growth rate assumption interacts with low interest rates. Such interaction benefits growth stocks the most, as their future growth opportunities look very high in present value terms. As a result, investors tend to overvalue (and overpay for) high multiple firms and undervalue low multiple firms. Hence, the growth stocks’ higher returns.
Two conclusions can be drawn from the above analysis and the chart.
On one hand, value investing seems to have shone after long periods of underperformance. If this is the case, and given the past seven-year underperformance of value investing, this may mean we may be at the threshold of a golden period for value investing once more. This is the optimist’s take and the good news.
On the other hand, and in a more pessimistic outlook, if value investing underperforms during periods of low inflation (and low interest rates) and if the outlook is for inflation to continue to be subdued along with interest rates for the foreseeable future, it may mean that an investing strategy that “naively” considers only low P/B stocks, including “smart beta” and factor investing strategies, may be dead for a while.
Fortunately, this is not what value investors do. The process they follow goes beyond “naively” investing in low P/B stocks. They invest in these stocks only if they can analyze them carefully and value them and find them to meet a predetermined margin of safety requirement.
George Athanassakos is a professor of finance and holds the Ben Graham Chair in Value Investing at the Ivey Business School, Western University.
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