Is It Time To Dump Value Investing?
Ben Graham, mentor of Warren Buffett, is commonly credited as the father of value investing. His book The Intelligent Investor, first written in 1949, promotes the idea of investing only in companies with a high ratio of book value to market value. That is, companies whose total net asset value (the value of all assets owned by the company minus its debt and other liabilities) is high relative to the market capitalization value of the company’s outstanding stock. The stocks of such companies are called value stocks, in contrast to so-called growth stocks whose prices (based on market capitalization) are high relative to their company’s net asset values. Graham’s assumption was that value stocks – which are not overpriced relative to the breakup value of the company – are not likely to fall as precipitously as the higher priced growth stocks if something were to spook the capital markets. This “margin of safety” approach to stock investing, as Graham called it, was actually more about risk management than about maximizing stock returns.
Much has been subsequently studied and written on this topic. In 1992 Gene Fama & Ken French, economists then at the University of Chicago, determined through academic research that value stocks outperform growth stocks over time. Unfortunately, in the investment world there is no free lunch. Although value stocks do have a higher margin of safety from a company bankruptcy standpoint, the higher returns this asset class generates come with a concomitantly higher risk or volatility. Regardless, value investing has become quite popular among many actively managed mutual funds and even among professional investment advisors as one way to beat the market.
As with any investment approach, the challenge is always to be able to maintain it in the face of unexpected underperformance. Value stocks have significantly underperformed growth stocks this year, as they have in 2015 and in fact over the last 10 years. Yet historically value has underperformed growth only 15% of the time over each 10-year period going back to the 1920s. Has something changed in the capital markets? Is it time to abandon any special focus on value stocks and start loading up our portfolios on growth stocks?
The problem is that there really isn’t enough data to definitively answer the question. Take 1999 for example. Value stocks underperformed growth stocks by over 25% in just that one year. By the end of the first quarter of 2000 growth stocks had continued their outperformance, returning another 5% over value stocks. A prominent value-oriented mutual fund portfolio manager was let go at that time after his fund had experienced significant shareholder redemptions. Yet from April through November, value stocks staged a remarkable turnaround, gaining over 26% more than growth stocks. By early 2001 value stocks were back in the lead when compared to growth, not just for the previous year but over the previous 1, 3, 5, 10, and 20 year periods.
What’s an investor to do in 2017? So far it’s looking a lot like 2000. After significant outperformance by growth stocks during the first half of the year, value appears to be making a comeback. Should you stay with a value-tilted portfolio or shift your focus to the more popular technology growth stocks? My belief is that it pays to stick with what has been shown to work long-term unless something has significantly changed in either the economy or the capital markets. Remember the late 1990s? Tech startups were less concerned about profits than they were about revenue growth, touting it as the new measure of success in the booming “new economy.” Investors were paying so much attention to this metric that the Federal Accounting Standards Board (FASB) was forced to create new revenue recognition restrictions. And as we all know, the collapse came in 2000, demonstrating that there really wasn’t any new economy, and that profits still mattered more than revenue. One clever TV ad referred to the new economy as being just the old economy but in T-shirts.
Investments will always go up and down (but presumably up in the long run). Whenever you invest in an asset class for the purpose of either reducing risk or improving return, there inevitably will be periods when the results do not match your expectations. If you’ve put good thought and analysis into your investment approach, have the courage of your convictions and try not to be swayed by the media or by current investment fads. The capital markets and the economy haven’t changed much in the last fifty years, so it’s unlikely things are different now.