What If Value Investing Is A Little Bit Dead?

This article was first published by me on Talkmarkets: https://talkmarkets.com/content/stocks–equities/what-if-value-investing-is-a-little-bit-dead?post=214196

I am not sure that it is, but I would like to explore some of the arguments that it may be. I have come across enough articles over the last year or so to suggest it could be broken, or even dead. If it is does that just mean as value investors we may need to tweak our approach slightly?

It has been a hot topic on various reddit value investing forums, so I thought I would weigh in with my 2 cents worth. Are the days of deep value investing working over?

On the one hand, you don’t want to abandon your investing approach all of a sudden. Then again you don’t want to have your head in the sand and not be open to slight tweaks.

Now let’s get one thing out of the way before I delve into this post. I realize value and growth investing may be “joined at the hip” as many would say. For simplicity now let’s just think of value investing more about some simple metrics such as low price to book or price to earnings ratios. Debating the differences in styles is a whole other topic!

This topic came to mind as I recently read an article discussing the underperformance of value investing strategies. It was from “The Economist” so one thing that came to mind is the theory that major news publications may emphasise market trends at key turning points.

I also thought that plenty of the points made about value investing having a rough trot could have been made in exactly the same way in early 2000. I re-read the article asking myself at the same time could this exact piece have appeared just before the dot com bust?

Now, this article is far from saying value investing has stopped working. It is fair to say it reflects that it is out of fashion. I don’t think the article discusses anything different from what I tended to read in 1999 /early 2000.

Why am I using this date as a reference point? Well after early 2000 the dot com bubble burst and for the next decade so-called value investing trounced the returns of growth investing.

Another article I came across this year I thought was an excellent read because it came from an investor trying to avoid confirmation bias. That is a value investor trying to debate the case against value stocks.

I still wonder whether similar arguments here were also made in the dot com bubble. Although I may think the arguments may be similar, I think the author makes some very good points though. In particular, as to why the arguments could have become more compelling now.

Should we be asking is it different this time? Maybe value investing won’t rebound from its slump like it did after the tech boom ended?

The case against value stocks

I shall quickly note the 5 headings in the post above on why value investing may not work so well going forward. Were the same arguments around in 1999, and have these 5 key arguments become more compelling now?

If we subscribe to the theories made, are there some tweaks that value investors can make to put the odds more in their favor?

[1] The World is Different

The argument here is that central banks are now interfering in an unprecedented way. This is a game changer in encouraging speculation so who knows when value may come back into fashion.

My thoughts – There is no doubt the level of central bank intervention is far more apparent than in 1999. Having said that though I recall similar arguments being made back then. The “Greenspan put” was a reason at the time why you should shun value investing. There were no shortage of critics arguing the Fed kept monetary policy too easy after certain events. These included the ’87 crash, the Asian financial crisis, LTCM crisis, and Y2K threat. This was supposedly a reason that speculation would continue and favour growth investing.

How can value investors respond? – I see the best response here is at the margin to not to be too cute in waiting for the ultimate dirt cheap level to enter in a stock you like. In 2009 I remember many compelling arguments why the market had much further to fall. It centred around the chart of historic CAPE ratios in the US.

I saw a lot of investors staying heavily cashed up as surely we would soon see the CAPE P/E of the market go at least down to ten. That never happened though. Perhaps central bank intervention is the reason here. If we wait for all the ducks to line up we may end up with too much in cash for long periods. I have noticed a fair share of value-style investors that have carried higher than normal cash weightings for longer than normal periods.

[2] Too Many People Are Doing It

The argument is that it has so commonly been mentioned that value investing works, that too many active funds have tried to exploit it. Has the alpha been eaten away?

My thoughts – I think you could say that this argument is more compelling now with the amount of smart beta ETFs around. They can attract large amount of AUMs and screen for basic value tilts in liquid stocks quite easily. This is more apparent than in 1999.

How can value investors respond? – I would suggest staying clear of large-cap US stocks that appear as classic value stocks. This is probably the area where the easy alpha may have been exploited already. There are probably some good US large cap value ideas there, but on average can you pick them and stay out of enough “value traps”?

[3] The Capital Following it is Becoming More Permanent

The argument here is that the behaviour of value investors is improving in having the discipline to stick with the strategy. That is, what makes it work is other investors capitulating with the strategy at the wrong time. This leaves bargain stocks to be scooped up by those who have the patience. Yet if everyone is patiently sticking with value investing for the long term, then when do such bargains pop up?

My thoughts – I am more sceptical on this argument as to me it implies that human nature is changing. I doubt we will witness great improvements in the investor psychology of the masses. There is always plenty of new investors coming onto the scene likely to make the usual beginner mistakes of panicking at the wrong time.

Once again though I can see a point that makes the argument more compelling this time. The asset management industry may have improved at selling the point of value investing working over the long run. Perhaps the clients are more willing to stick to the strategy for longer than they used to.

How can value investors respond? – Arguably this just involves sticking to a value strategy now for a bit longer. Perhaps above just explains why the underperforming run of value managers has gone on for so long. Maybe we have not seen a capitulation in value-based strategies. Is this just around the corner?

There will no doubt still be bouts of panic. Despite the strong markets as I write now, we have still had a little nervousness as recently as in Q4, 2018. Part of what seems to have assisted this year has been dovish central banks globally, which ties into point 1 earlier. We have still seen a few bouts of panic and the VIX spiking on several occasions since the 2008 bear market. As value investors maybe we need to be quicker in pouncing during these opportunities and running those cash levels down.

[4] Big Data and Rising Computing Power Are Leading to More Value Traps

This refers to the sophisticated use of computing power that puts you ahead of researching via basic valuation metrics. The example being say a large old bricks and mortar retailer appearing to have a cheap valuation. Yet then you apply a sophisticated analysis of parking lot numbers being down. Or you get the heads up from credit card providers that indicate transactions may be slowing. Meanwhile, the rest of the market can be slow in discovering these are value traps.

My thoughts – On one hand it makes sense because funds management became a great industry to get into in the 90s. This no doubt lead to intense competition between active managers over time. You often read about veteran fund managers in the US speaking about it being more difficult there nowadays to spot opportunities in comparison to the 60s and 70s.

The intense research they undertake no doubt crowd out many opportunities. A similar argument could have been made in 1999, although perhaps the technology available now crowds out even more opportunities with all the stock filtering one can do.

One thing to keep in mind though is the general shift of money away from active to passive strategies in the US in recent years. This could be an argument that better opportunities to add value may come about in the future from this trend.

How can value investors respond? – The level of competitiveness of fund managers using sophisticated research is less I assume in markets other than the US. Likewise the smaller we go with company sizes we invest in it should be less competitively researched.

Hard work if one also has the time could pay off in small caps. For example, some companies may have assets on their balance sheet conservatively valued. Do accounting methodologies mean some tangible assets are still undervalued at cost? It may escape the radar of some investors if they are only screening by the reported NTA.

Or are companies that are generating improving cash flows under the radar? Perhaps such improvement is yet to show up for investors filtering based on profits. Or they may be excluded if they are filtering out companies with relatively high historical debt levels.

Now I imagine many well-researched fund managers are all over this type of thing. That is particularly when it comes to mid-cap or large-cap stocks in the US. If you are an individual investor hunting for small caps though it may throw up some opportunities.

This may or may not involve shareholder activism to unlock value. I have read reports suggesting that in the US activism may fit in the “too many people are doing it” bucket there, but not so much in other countries.

At the very micro-cap stock level your own experiences with the company’s product, customers, suppliers etc, knowing the shareholder base might be able to give you an edge. The very sophisticated computer research power refereed to in this heading would likely be used by larger asset managers that can’t take positions in very small micro-cap stocks.

[5] Value is a Bet Against Technology

The point here is that a value approach will likely be a relative bet against technology in terms of the typical equities’ benchmarks. With some of the higher P/E global tech names getting so large these days most would agree with this.

My thoughts – Firstly as the article points out you could simply adopt similar sector exposures to the major global indices anyway. It doesn’t have to be the case that you are underweight the tech sector. You could apply more of a traditional value approach to the tech sector instead by picking your own tech stocks.

If a value investor’s portfolio does fall out with an underweight tech bet against the index there is certainly no guarantee that is a bad thing going forward. The same fear for value investing strategies was put forward in 1999. Clearly, the internet had a dramatic effect on our lives over the next decade, perhaps even more so than we could imagine at the time. Yet we still saw value investing outperform growth strategies during this time by a big margin.

A lot of the success in growth investing in recent times could be put down to larger tech giants being successful. History shows that it isn’t easy for such giants to stay at the top. Can we as a society spend more time using the likes of YouTube, Facebook, Netflix etc than we are already doing today?

I expect that the number of hours per day will stay relatively flat at 24 anyway! Will natural competitive forces or even regulation limit the longer-term growth potential of the major players?

I want to make it clear I am not necessarily predicting their demise or shorting these stocks. I am merely raising the point that going overweight tech is not a sure thing to outperform going forward.

How can value investors respond? – I want to stress I don’t think now is close to resembling the sort of froth in the tech sector resembling that seen prior to the tech bubble bursting in 2000. It is my view though that there is rarely an obvious sector bet in the markets that exist.

One approach to counter this risk though is to look for companies where their exposure to technology may be relatively hidden. Some “old economy” stocks may be quietly building up a transformation story in the tech sector, yet not labelled as such within official sector classifications. Once again such hidden gems are likely to be found outside the major US companies.

Conclusion

I can see some greater strength in the arguments that value investing may continue to struggle this time. For instance, I would be reluctant to bet strongly on basic smart beta value investing strategies in the large-cap US market. Dare I say it, perhaps value investing has died a little there, and it is different this time.

I do however think that many of the arguments made why value investing is dead are not a whole lot different to points raised some 20 years ago. This was prior to a massive outperformance by so-called value investing strategies over the following decade.

As I have written above I think there may be some areas to drift to for value investors just in case the critics are correct with many of these arguments.

To summarise this can mean hunting for value investments in smaller companies and more so outside of the US market. The bad news is it might involve a bit of work.

In terms of some more arguments to favor this approach I just mentioned above, I will add a few links below. The articles further down could indicate there are tailwinds for looking in such areas and that now may not be a bad time to start.

For investing outside of US markets, now might be a reasonable time?

Are active value strategies better off being used across Asia and Europe?

Admittedly these articles are based on fairly limited timeframes but the messages within may still be relevant and provide food for thought.

Active Investing Trumps Passive Funds…in Asia

Active vs Passive How the Debate Stacks Up in Europeex-UK Equities

Active vs Passive in Emerging Markets

Will small-cap value strategies rebound once market breadth finally improves?

Then again perhaps I am a value investing dinosaur suffering confirmation bias, and the whole game has changed now. It does feel a bit that way right now!

4 thoughts on “What If Value Investing Is A Little Bit Dead?”

  1. For what it is worth, Steve Johnson from Forager recently wrote that in the current investment environment value alone is no longer sufficient to justify an investment and that in future they will include share price momentum in their assessment. No doubt the passive fund managers will be feeling the heat from under-performance.

    1. That’s interesting James, I hadn’t yet seen that they made that comment about momentum. They probably feel compelled to make at least some tweak here and there given the poor run. I thought I read a hint that they may be a bit more “activist” like with some of their investments going forward.

      At least the Australian fund doesn’t have to stress about redemptions now that it went to the closed end format.

      Their since inception alpha is quickly getting peeled away. Sometimes there can be a couple of issues with institutions using their style versus a private investor.

      Firstly if the thesis changes and they want to exit a position it can be difficult in their smaller stocks. For instance a private investor could get out quickly with a stock like Freedom Insurance. Secondly there must be a lot of stress lagging the benchmark over a one year period like that managing other people’s money. Clients are constantly questioning the style.

      I’m not brave enough to weight my individual direct small stocks as large as they do sometimes in their portfolio. So I’ll never beat the indices like they were doing a few years ago, but equally not likely to underperform by as much over a 12 month period.

      I think I put the jinx on Forager as I have mentioned them on the blog as a good fund manager to watch what they are doing! They underperformed a lot initially when they set up the fund so they can bounce back again.

  2. Great comments re Forager
    I was thinking in fact that Momentum chasing passive funds may be creating the ‘death’ or ‘illness’ in the small, vaue names being left behind.
    One solution would be to wait for these momentum guys to stop or reverse rather than piling in to the momentum strategy at this late stage.

    1. Yes the performance chasing becomes self fulfilling so who knows when the trend changes. Many thought Nasdaq was way overvalued at the beginning of 1999 (in some ways this view was arguably correct given it went no where for a decade), but it still doubled within the next 12 months.

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