Value investing is the investment style of purchasing stocks at a price below their true worth. This investing method was developed in 1920s at Columbia Business School by Benjamin Graham & David Dodd, both considered pioneers in the field of security analysis.
It has proven to be a very successful style of investing until the early 2000s and rewarded stalwart value investors like Warren Buffet with exponential returns. There are nine popular principles of value investing of which, we shall expound the three considered the most crucial (Rosevear, 2018).
First, value investing is not speculation. In his classic book on investing, ‘The Intelligent Investor’, Benjamin Graham, the grandfather of value investing, emphasized: “An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” Thus, value investors purchase stocks which they believe are trading at sizeable discounts to their current actual worth in the hope that other investors will eventually realize their true worth and the stock price will rise. Speculators, on the other hand, simply seek companies that are projected to have greater value in the future.
Second, value investors desire stocks with a healthy margin of safety. Margin of safety is the difference between a stock’s current market price & their intrinsic value. It signifies the upside potential as measured by the price-to-book-ratio. Companies whose market capitalization is less than their book value are popular targets in value investing.
Third, value investors seek a premium over market returns over their investment horizon. This usually involves staying invested in an index fund whilst being on the hunt for value stocks with a healthy margin of safety together with potential to outperform the market.
The other popular style is growth investing and in certain ways, it is the opposite of value investing. Growth companies have tremendous earnings growth potential and are usually valued at a lot more than the book value of their assets. Since 2010, we can see that growth stocks have been outperforming value stocks. There could be many explanations for this, and we shall explore the possible explanations.
Recent Performance of Value Investing
The performance of value investing has been poor for the last couple of years (Commins, 2019). As we can see in the chart above, the divergence between the returns of the MSCI World Index and the MSCI World Value Index has been growing (Klassen, 2019). The MSCI World is a market cap-weighted stock market index representing 1,655 global stocks, while the MSCI World Value Index represents global securities exhibiting value-style characteristics. From 2014 to early 2017, we see that the performance of both indices is relatively similar, but there is greater performance deficit in value stocks since then. Value stocks tend to be defensive in nature and must protect portfolio value during market downturns. This has failed to be the case in recent times. In fact, during the worst performing months, value investing worsened the portfolio value as indicated in the table below.
Growth investing vs Value investing
Whether growth or value investing is the better option, has been debated over decades (Watling, 2019). The key characteristics of growth investing are buying stocks with high P/E ratios, high earnings growth rates, high price-to-book ratios, low dividend yields and high volatility. Value stocks have exactly opposite characteristics. In the diagram below, the blue line represents the relative performance of large-cap US growth stocks vs large-cap US value stocks. For several years now, the blue line is having an upward trend implying that the growth stocks are outperforming the value stocks. However, this does not mean that the trend is here to stay. Value stocks consistently outperformed growth stocks from 1930s to 1980s before the trend reversal. Choosing one style or the other is ultimately up to the investor’s preference and beliefs. Both strategies have proven to be successful at different points in time.
Possible Reasons for the Recent Under-performance
If we were to look at the markets over the past 10 years, we would find ourselves in a strange paradigm where low growth and low interest rates have become the norm. It is estimated that over 30% of the global fixed income is currently trading with a negative yield. Most firms are expected to grow at the trend growth rate of the economy and therefore employ leverage to improve profitability. A low growth economic environment adds pressure on firms to generate profits. This does not bode well for value stocks. The low interest rates also improve valuations of levered firms due to a lower discount rate. This means more companies start looking like growth stocks. Over the past decade, more and more investors have poured money into growth mutual funds whilst fewer and fewer high-growth companies have emerged over the same time. These days, the ‘disruptive’ technology companies are the ‘darlings’ of the market and they trade at multiples that would never make sense to a value investor.
Besides the economic factors, there are fundamental reasons that have altered the nature of value investing; and technology is the likely cause. Economic moat, a term popularised by Warren Buffet, represents a firm’s competitive advantage over its competitors; and for several industries, the economic moat has dramatically transformed due to technological disruption. For example, the growth of ecommerce has shut many brick-and-mortar stores and it shall continue to disrupt other parts of the retail sector. While Amazon expands its customer base and uses data analytics to explore more revenue streams, a large part of the retail sector is trading below its historical average. This means that, in case of all those industries facing low growth, eventual mean-reversion is questionable at best. So, a lot of the value stocks have failed to meet their potential and have underperformed as a result.
Business models have also undergone a transformation. Many of the newly successful businesses would look terrible to a traditional value investor. Conventional business models had most of their value reflected in their balance sheet. However, several successful technology companies operate with fewer fixed assets (e.g. Airbnb versus Hotels) and higher marketing expense which brings in the revenue. Traditional metrics like price-to-book value will possibly fail to accurately classify these businesses as growth or value.
Although there is empirical and logical evidence for value investing to be cast aside, we have observed a sharp reversion at the start of September 2019, when momentum stocks lost 10% of their value and value stocks rallied 7%. That was one of the sharpest such three-day shifts in 30 years. Also the slump in value investing could just be part of a cycle when one style trumps the other; which means the tide could turn at the end of the cycle and generate profits for value investors (Borate, 2019). While it is uncertain if this kind of shift will continue, it is quite certain that value investing is in the doghouse and is unlikely to return to its glory days anytime soon.
Borate, N. (2019, 2019-07-23). ‘Value investing hasn’t worked in past 8-9 years, but then cycles change’. Retrieved from https://www.livemint.com/money/personal-finance/-value-investing-hasn-t-worked-in-past-8-9-years-but-then-cycles-change-1563822468701.html
Commins, P. (2019, 2019-07-18). Why value investing is still in the dog house. Retrieved from https://www.afr.com/markets/equity-markets/why-value-investing-is-still-in-the-dog-house-20190718-p528gh
Klassen, D. (2019). Value Investing: a religious experience. Retrieved from https://www.livewiremarkets.com/wires/value-investing-a-religious-experience
Rosevear, J. (2018, 2018-05-26). 9 Key Principles of Value Investing | The Motley Fool. Retrieved from https://www.fool.com/investing/2018/05/26/9-key-principles-of-value-investing.aspx
Watling, C. (2019). Value vs. growth. Retrieved from https://www.livewiremarkets.com/wires/value-vs-growth
The CAINZ Digest is published by CAINZ, a student society affiliated with the Faculty of Business at the University of Melbourne. Opinions published are not necessarily those of the publishers, printers or editors. CAINZ, its Partners and the University of Melbourne do not accept any responsibility for the accuracy of information contained in the publication.
Laukik is a Master of Finance student and a CFA Level 3 candidate. An interest in global economic developments, technological advancements and investment strategies has driven him to pursue a career in asset management. When his head isn’t hidden behind a laptop, he is in the gym doing burpees and mountain climbers!