The Intelligent Investor? Keep the Value Investing Books on the Shelf
Value investing has long been the art of investing in undervalued companies in search for returns. The practice has made a renowned few massive amounts of wealth and along with the financial success, amassed a following of undying disciples. Unfortunately, the current economic environment has brought upon a drought on capital markets, leaving growth stocks as the single oasis where investors can quench their thirst for returns.
Popularized by Benjamin Graham in the 1930s and embraced successfully by pupil Warren Buffett, value investing is one of the first and most consistent ways to beat the market. At its simplest, the approach holds that equities selling below their intrinsic value will perform better over time. The entire concept is now being put to question in view of the fact that value investing has been lagging by a considerable degree for quite a while. The iShares S&P 500 Value ETF, an exchange-traded fund that tracks the undervalued stocks in the S&P 500, has consistently underperformed the market for over half a decade. As well, the Russell 1000 growth index has increased by 30% this year alone; in contrast, the Russell 1000 value index has hemorrhaged a 10% loss within the same year. US growth stocks have seen returns thrice that of value stocks in the past 10 years, rising as much as 300%.
We must re-value the thesis behind value. The performance of value stock investors has declined considerably relative to that of growth investors due to the pandemic. The current economic environment, plagued with low interest rates and an overall sluggish sentiment, has assisted the climb for growth valuations. The re-evaluation arises from the long period of sustained low interest rates that precipitated the fall in performance for many value-based money managers. The results of the investing paradigm have proven tragic. On October 14, quantitative fund manager AJO Partners released a statement announcing its shut down at the end of the year with intentions of returning the $10 billion under management to its clients after suffering major losses in a number of its value funds.
Value investing has lost its value given the length and depth of the latest downturn. Andrew Lapthorne, head of quantitative research at Société Générale, wrote in a note last week that “We have read plenty of value factor obituaries over the decades, but let’s be clear: value performance is bad, the worst it has been in 100 years.”
When central banks rule capital markets as kings, value stocks are buried. Expansionary monetary policy and the ensuing low interest rates harm value stocks to the same extent that they benefit growth stocks. The classical factor investing strategy (Buffett’s claim to fame) becomes increasingly irrelevant at a time when quantitative easing and technology reign supreme. Popularized by the legendary Berkshire Hathaway chief executive, the strategy aims to acquire stocks that trade at a cheap price relative to its book value. The threat of low interest rates is of material significance for the metric as the multiple is a function of interest rates. As rates converge to zero, today’s reality, the price-to-book ratios of stocks climb substantially above historical levels. A correlation exists between the performance of value stocks and the direction of bond yields, with the latter driven by the economy.
While historical data demonstrates that value performs badly when yields fall, the opposite also holds true. The ability to purchase cheap quality companies in such an environment diminishes notably, and thus the companies trading at low price-to-book ratios tend to be lousy ones. Value opportunities become increasingly limited for managers whose mandate is exclusively restricted to such an approach. Ease in monetary policy and added monetary stimulus, a consequence of the pandemic, has in the aggregate lifted valuations, resulting in even lower premiums on cheap stocks. The product is a lengthy cycle of underperformance for value equities.
As taught by most business schools in today’s day and age, the price-to-book ratio is also a function of the growth rate of earnings going forward. This unique relationship, adapted from the infamous equity valuation model, leads to lower multiple valuations for those firms that are expected to have low earnings growth prospects in the future. Conversely, companies that analysts deem as having high earnings growth potential will receive higher multiple valuations. Economists and investors alike regard low interest rates as catalysts for growth, which translates to optimistic future cash flow assessments within capital markets. Mathematically, this means future growth opportunities appear remarkably elevated in present value terms.
The takeaway is best voiced by one of BofA’s latest statements, “More than three-quarters of value’s relative performance versus growth is explained by rates, inflation, and the business cycle.” In short, the first obstacle facing value investors is inherently macroeconomic. The second obstacle is the increasingly antiquated value factor as defined in the classical sense of financial literature.
As the world adapts and changes, so should valuation methods. Unfortunately for the value investor, the book value metric fails to fully grasp the extent and importance of the latest most valuable commercial asset, intangible innovation. The book value represents a company’s value according to its books as seen through its financial statements. The financial theory is such that the book value corresponds to the total worth of the company, given that all assets are sold and all debts are repaid. This metric highlights how much each shareholder would receive provided that the company was to be liquidated. At its simplest, the book value is a measure of a company’s assets minus its liabilities.
This measure is outdated due to the fact that the metric fails to include intangible assets such as brands and intellectual property. Nowadays, those two components account for more of a company’s worth than hard assets like factories (think Tesla). Investors fail to come to terms with the “highly-inflated” valuations, as the value seems to be an outcome of excessive optimism, but the loyal fandom the company has developed is unparalleled. When the customer’s perception is a company’s biggest asset, there is no form in which its value can be translated to paper. Brand equity has served Apple well throughout the years, and Tesla will likely experience similar benefits.
The metric thus positions restricted value mandated money managers at a disadvantage. Companies with high intangibles – tech companies – often possess low levels of assets, leaving value managers unable to take advantage of the growing opportunities in the industry. The latest rally and the change in habits and behaviour the pandemic induced have permanently disrupted industries and powered the FAANGs, pushing the gains of growth investors higher. The last few months have seen the market led by Big Tech, making up over 66% of the S&P 500 gains.
What do tech and innovation mean for Buffet’s beloved ‘moats’? Moats represent distinct competitive advantages companies have over their competitors and new entrants, which protect their market share and profitability. Technology has destroyed barriers of entry in many industries, making it harder for incumbent companies in traditional industries to protect their dominance. Book value is rendered useless when faced with the growing tech sector. The pandemic has propelled and turbocharged the adoption of tech and everything that it means for entertainment, work from home, education, leisure, and consumer retail. Moats that used to be of tremendous value pre-pandemic are likely to go extinct as new behaviours are adopted by entire generations. Value investors have fallen deadly ill to the current rotation towards growth stocks; a cure will only be possible through massive global vaccinations and economic expansion.
Should investors bother to pick up their value investing guides from their shelves and revisit this antiquated strategy? Will a comeback for the practice ever return as intangible assets become of increasing value? It might be time to put away the value textbooks and pick up a “how to build a growth valuation model” book. It is unlikely that in the near future, central banks will loosen their reigns on capital markets or abandon their dovish monetary policies; if so, perhaps value investors will experience a renaissance of sorts. The ultimate black swan in favour of value investors would be seeing lofty valuations burst. For young investors loyal to their value investing heroes, here is a little survival tip: treat hopes like one does taxes… defer them.