Winner of CFA UK and Brandes Essay competition 2020

Author: Masahiro Onizuka, CFA

Value has underperformed since around 2008, although its philosophy is indisputable. In practice, value investors buy stocks with cheap value metrics. This worked historically. However, current digital revolution may be akin to the Industrial Revolutions in impacts. Value-adding value investors should acknowledge this possibility first before thinking about value.

Is there now ‘value’ in value investing ? 

Introduction

This is a particularly pertinent question, as the period since the Great Financial Crisis of 2008 was marked by persistent underperformance of value, notably in the US stock market. Dedicated value investors’ typical argument is that value has historically outperformed, and the observed underperformance of value is essentially just a dry spell which will reverse soon. As this supposed anomaly exhibits longevity, however, naturally the above question is being asked more frequently.

In this essay, I argue that...

• the basic tenet of value-investing philosophy indisputably has value;
• the issue may be in the standard value-investing methodology, which centers around buying stocks which are considered cheap on the basis of typical quantified metrics of value, such as price-to-book and price-to-earnings;
• such methodology has worked for a long time, which is why dedicated value investors expect a reversal of value underperformance within a reasonable timeframe;
• however, historical data from which we are drawing this conclusion may not be long enough to be called “history”, once we acknowledge the possibility that current digital revolution may have Industrial Revolution-kind of impacts;
• no one knows whether we are having another Industrial Revolution, but value-adding value investors should focus on whether they are thinking really carefully about value in the face of such great unknowns.

Value-investing revisited

In its most basic tenet, value-investing means buying stocks at a price which is below intrinsic value of the business and incorporates sufficient margins of safety. Assuming that the price eventually converges towards the intrinsic value, value-investing clearly has value. This cannot be disputed.

However, not only value stocks but also growth stocks can easily fit into this definition of value-investing, as long as stocks are bought at a price below intrinsic value with margins of safety. In his seminal book The Intelligent Investor, Benjamin Graham acknowledged that value-investing philosophy might in theory be implemented for growth stocks too;“...the growth-stock approach may supply as dependable a margin of safety as is found in the ordinary investment - provided the calculation of the future is conservatively made and provided it shows a satisfactory margin in relation to the price paid”¹. 

Nevertheless, he was against growth-investing, because of the difficulty to identify successful growth stocks consistently:“...the investor who can successfully identify such “growth companies” when their shares are available at reasonable prices is certain to do superlatively well with his capital...But the real question is whether  or not all careful and intelligent investors can follow this policy with fair success².” His argument is realistic and likely resonates with many investors’ experience. Because of this, value-investing in practice means buying stocks which are considered cheap on some quantified metrics of value, such as price-to-book ratio or price-to- earnings ratio.

Value-investing before 2008 great financial crisis

One of the best known research paper which quantitatively demonstrated that cheaper stocks did earn excess return was that of Fama & French (1993)³. They used book-to-price ratio to quantify cheapness. There are other research which used different metrics of value. These research collectively demonstrated robustness of the conclusion that cheap stocks as a group did tend to earn premium, at least until around the GFC of 2008.

Such quantitative validation of value as excess return earner is important when arguing for value-investing strategy. For an investment strategy to be valid, it must skew odds of success in your favor. Otherwise it is not “strategy”, but a series of case- by-case bets, with each having 50/50 chance of success on average. Recall that Graham opposed growth-investing because he considered odds of success low. Fama & French showed that value-investing tended to succeed, because probability is skewed in favor of value investors. In a way, this means that success of (at least some) value investors was not necessarily due to stock-picking skills, but due to the underlying pattern of market return. If you have a portfolio of stocks when markets rise, it is likely to generate profit simply because more stocks will rise. In a similar way, for a long time, we had a market condition which tended to let you outperform simply by having value bias, as value stocks as a group tended to earn excess return. 

This is not to belittle Graham’s value-investing philosophy or early adopters of his philosophy like Warren Buffett. Graham identified an approach which skewed odds in our favor and therefore could be used successfully by many. It is “strategy” in the proper sense of the word. Buffett’s genius was that he understood the merit of Graham’s approach and implemented it very well, long before computational computing power developed enough to quantitatively validate Graham’s strategy.

Value-investing after 2008 great financial crisis

A big problem now is that this historical tendency of value stocks to outperform appears weakening. The charts below, taken from the massive new piece of research by Research Affiliates LLC⁴, starkly visualize the issue. The green line (“HML”) follows Fama & French (1993) and uses book-to-price as a measure of value. There is a valid argument that intangible assets are more important in our time and using accounting-based book-to-price does not make much sense. The authors thought about it and did further analysis using a measure of value calculated with capitalized intangibles (the blue line, “iHML”). They showed that iHML did outperform simple HML, but again iHML began struggling to outperform growth around 2008.

What stands out in this chart is a trend change after the GFC. Previously, underperformance of value was temporary and appears to coincide with identifiable events, such as the Oil Crisis and tech bubbles (see the chart below which marks various events on the “HML” line). Overall upward trend of value outperformance remained. After the GFC, however, overall upward trend ceased and we cannot identify any specific short-term events as a reason. This change in market behavior impacts value investors regardless of whether their approach is purely quantitative (i.e. value factor investing) or fundamental. Negative impact on the former is obvious. Fundamental value investors also suffer, as it implies that their hunting ground contains less attractive targets and this reduces odds of success.

Debate continues on why this is happening. As is often the case in times like this when past patterns appear breaking down, there are those who argue that ‘this time is different’. On the other hand, dedicated value-investors present various analysis in support of their style in an counter-attack. Unfortunately, in the end, many of arguments cannot be conclusively affirmed or refuted. Some of the examples⁵ are as follows.

• Low interest rates: After the GFC, many developed counties followed Japan’s path and entered an era of low interest rates. Some point out that, in the standard Gordon formula for stock valuation, low rates should have a disproportionate impact on longer-duration, lower-yielding assets. Growth stocks with long lead time before settling into a cash cow status and without current stable dividends fit into this profile. This argument stands, however, only if low interest rates does not imply a significant drop in future growth expectations. Does the low rate mean that growth expectations fell for growth names too ? No one knows for sure.
• Growth of private markets: This argument posits that private equity investors buy undervalued stocks and take them out of public markets. This leaves fewer value opportunities and lowers expected return on value. But some point out that, given the growth of private equity, the buying pressure should increase prices of deep-value stocks when they become private equity targets. This counter-argument is certainly plausible, given that global private equity AUM is reported to have surpassed US$4 trillion⁶, and how leverage of US buy-out deals appear rising, as shown in the graph below⁷. So is the growth of private markets hurting or helping value-investing ? It is hard to tell.
• Digital revolution: Huge growth in the digital sector observed over the last decade or so is another argument. This narrative suggests that disruptive new technology is driving brick-and-mortar value companies into irrelevance. In response, value investors question the sanity of valuation given to some technology stocks by pointing out past instances of growth stars fading into obscurity as they turn from being a disruptor to the disrupted, sometimes pretty quickly. Again, debate goes on without a conclusion, as both camps get entrenched in their respective bunker.

We face the unknows

While the jury is still out on many of these potential explanations, I think that one of them requires a particular attention – technological revolution. I emphasize that I am not buying into the illusion that this time is different and hefty valuation of some large technology stocks can stay there forever. One day, their growth will slow. They may simply run out of room to grow. They may be disrupted by another technology company. They may grow too large to be effectively managed. There can be a number of potential reasons why their valuation can crash in the future. My argument is that these are beside the point if we care sincerely about whether there is value in value-investing.

Going back to the issue of how value investors have defended value-investing in the face of struggle since the GFC, ultimately it boils down to the observation that value historically outperformed and there were periods of technology hypes in the past which ended badly. But is the data from which we are drawing these conclusions long enough, if the technological revolution of our time eventually comes to have the kind of impacts akin to the Industrial Revolutions, for example ? Clearly not, as these events happened in the 19th and early 20th centuries.  

Some may discount this as a fanciful exaggeration of what is going on, but how can they be sure ? The Industrial Revolutions, when happening, were likely not fully understood by many who were in the midst of it. Only later, historical study shed light on the full implication of these tumultuous events, which disrupted a number of industries and made some previously valuable assets almost worthless. When railways and cars came onto the scene, people did not go back to horses as a means of transport. Modern business practices enabled by advancement in science and engineering wiped out those who could not keep up with the changes. Now let’s look at the current technological revolution. For example, we can see online shopping is already a fact of life for many. As years pass by, we can be marching towards the world where literally everyone knows how to shop online and will shop online most of the time. In this world, what value will brick-and-mortar retailors have ? As the COVID-19 crisis painfully demonstrated, technology has developed enough to enable a large-scale remote-working, which few had thought possible until this forced experiment took place. Now, what’s the long-term value of real estate companies with large office property portfolios ? And these may be just a tip of an iceberg. If the Internet of Things (IoT) truly takes a center stage in many industries and becomes the source of value which customers pay money for, are we sure that value stocks of today are still value stocks of tomorrow ?

Are we witnessing the next Industrial Revolution ? Again, we don’t know. All we can say is that there is such a possibility, and this is the point. At least, once we accept that this is a real possibility, then we can say;

• it is dangerous to assume that we have enough historical data to conclude that the underperformance of value observed since the GFC is an extreme anomaly which must be just about to reverse – data we have may not be long enough to be called “history”;
• it is dangerous to discount that what is happening is just a repeat of past technology bubbles like the dotcom.   

Often, the more dedicated we are as fundamental value investors, the less time we are likely to spend trying to understand what is going on in technology. The more quantitative we are in our approach, the more prone we may be to lack truly historical perspectives and think that we have enough data if data goes back 50 years. These can make us trip over. 

I don’t think that value investors need to reinvent themselves as growth investors, but I feel that value-adding value investors should focus on refining their way of thinking about value in the face of these great unknowns. By just acknowledging that the technological revolution we are seeing may have far bigger implications than we previously recognized, we will become less dismissive of what is going on, more careful in thinking about value, and more selective. The last thing we should do, in my view, is to retreat into our bunker and ignore any possibility that we may have missed something important initially. Only accepting evidence which matches our pre-existing belief is known as confirmation bias. What is truly scary is that we can easily fall into this trap while believing that we are following a time-tested principle. I think that, under certain circumstances, there is an extremely fine line between suffering from confirmation bias and following a principle, and there is no way to tell which is happening to us. If so, what we need to maintain is flexibility and the willingness to look at the issue from a different perspective. This is what I am arguing for.

The most import message from Graham

The key tenet of value-investing advocated by Benjamin Graham - we should buy stocks at a price which is below intrinsic value of the business and incorporates sufficient margins of safety – is timeless and beyond dispute. However, to my mind, the most important messages from him is not specifically on value-investing per se, but on the attitude to approach investment. He wrote; “Investment is most intelligent when it is most businesslike8”, and “You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right9”. To me, businesslike attitude means that you at least take a second look at your earlier conclusion if evidence mounts that you may have drawn a wrong conclusion from insufficient data in the face of great unknowns. 

There will be time when technology stocks with sky-high valuation come to collapse. It may happen tomorrow, or it may not happen for years. Either way, when it happens, it can present a moment of victory for value philosophy. But then what ? Technological revolution can continue with different new stars and change industries in the way we do not yet fully envision. Value-adding value investors should not be concerned with the question of when growth stocks may collapse. We should be concerned with the question of whether we are thinking really carefully about value in the face of great unknowns.

References

¹ Graham, B., The Intelligent Investor: The Definitive Book on Value Investing (revised edition), HarperCollins, p.517

² Graham, B. & Dodd, D.L., Security Analysis (6th edition), p.368

³ Fama, E.F. & K.R. French (1993), Common risk factors in the returns of on stocks and bonds, Journal of Financial Economics 33, p.3-56

⁴ Research Affiliates LLC (2020), Reports of Value's Death May Be Greatly Exaggerated

⁵ Research Affiliates LLC (2020), Reports of Value's Death May Be Greatly Exaggerated

⁶ Preqin, Private Equity Crosses the $4tn Threshold in 2019, 4 February 2020

⁷ Bain & Company, Global Private Equity Report 2020

 Masahiro Onizuka, CFA is a Senior Portfolio Manager at Manulife