Back in October, I was hopeful that a rotation out of highflying technology stocks and into cheap laggards would help to support the market. I was wrong.
The cheaper stocks—known as “value” stocks—fell less far, but failed to prevent a much broader rout. Worse, the rotation itself lasted little more than a week at the start of October, and this year, the normal postcrisis pattern of value underperformance has resumed.
I’m a believer in buying stocks cheap, so this is yet another disappointment. After a dozen poor years for value, should I give up and join the herd buying into the glamour of acronym stocks such as the FANGs: Facebook (FB), Amazon (AMZN), Netflix (NFLX) and Google parent Alphabet (GOOG)?
My answer is no, but I’m a lot less certain about it than I once was. Here’s why.
First, value has been terrible for a very long time. A strategy of being long value stocks—defined as those with a low price-to-book ratio—and short expensive stocks has lost money for 12 years, with only the occasional brief respite. The strategy has lost as much before: During the dot-com bubble, it was atrocious. But never have value investors been ground down for so long. Indeed, the previous longest period of loss was in the second phase of the Great Depression, according to Prof. Ken French at Dartmouth’s Tuck School of Business.
Second, everyone now knows about value’s wonderful record of beating the wider market over long periods, aside from the past dozen years. If value worked historically because investors overreacting to bad news made stocks too cheap, investors aware of value’s great history are now less likely to overreact. More money chasing value strategies should mean value stocks never become so cheap in the first place.
Third, and following from that, value itself isn’t particularly cheap. It’s true that value stocks have hardly ever been this cheap relative to the wider market, at least when measured on price to book, according to California-based Research Affiliates. But they aren’t especially cheap. At 2.3 times book value at the end of February—for the MSCI USA Value index—value stocks were at the same multiple as the wider market was just before the Black Monday crash in 1987. Measured on price-to-earnings estimates for the next 12 months, their 13.5 times multiple is no bargain compared with their own history, either.
The reason for value’s underperformance is hotly debated, but appears to be in large part because growth stocks have avoided the usual pitfalls. Expensive stocks are almost always priced at a premium because of their growth potential, but throughout history that premium was too big: Their earnings did grow faster than the wider market, but not fast enough to justify such high prices. The past decade has been different, as growth stocks beat earnings expectations. Trendy big companies such as Apple (AAPL), Facebook and Alphabet are obvious examples, but in virtually every sector, the strong companies have grown stronger, and value investors missed out on them.
Some of this shows up in Prof. French’s data. When stocks are treated equally, instead of the usual approach of weighting them by market capitalization, there’s been very little difference between value and other stocks since 2007. Put another way, the heavy underperformance of value was skewed by big moves among large companies. Treat big and small the same, and value basically matched the market.
Switch back to the market-weighted gauges and split them into the 30% of cheapest stocks, 30% most expensive and 40% in the middle, and guess what? The cheap stocks were almost as good as the middle, while the 30% expensive did far better. It wasn’t so much that value underperformed, as that a group of large go-go growth stocks outpaced everything else.
This isn’t to say that value’s underperformance is purely about the FANGs. Value investors over recent years held far less in the fashionable tech and biotech sectors, and more in out-of-favor sectors such as utilities and banks. That hurt. The four biggest drags on MSCI USA Value were its lack of any Apple, Amazon or Alphabet shares and its large position in Citigroup (C). But the sector split accounted for only about half the gap between value and growth.
Since January 2007 MSCI’s main U.S. value index returned 6.1% a year, including dividends, while a sector-neutral version came in at 7.8% a year, just below the market’s 8%, as it held stocks in better-performing expensive sectors, too. But the growth index was well ahead with a return of 9.7% a year. In case you think these numbers sound small, that’s the difference between turning $100,000 in 2007 into $200,000 now with the value index, $250,000 with the sector-adjusted value or $300,000 with growth.
What accounts for the rest of the gap? Some of it is surely that a winner-take-all approach seems to be emerging in many sectors, helping growth stocks keep growing.
Another issue, though, is that back in 2007 value was just coming off one of its best runs in history. From its dire result in the dot-com bubble, value went on to have seven straight years of outperformance for the first time since the U.S. joined World War II. That great run surely attracted investors to the strategy, making it work less well. My hope is that the constant disappointment of recent years has driven away enough investors to set up value strategies for a successful future. My worry is that there’s still plenty of big investors putting money into what they call the value “factor,” and it may take several more years of underperformance before they give up.