By Jack Forehand, CFA (@practicalquant)
It would be an understatement to say that the last decade has been a challenging one for value investors. The problems were initially isolated to certain value metrics (i.e. Price/Book) and more contained in strategies that overweighted certain sectors, but in the past few years the damage spilled over into pretty much any way you tried to represent value. And just when it seemed things couldn’t get any worse, the coronavirus came in and dealt one more horrible gut punch to value.
But in the wake of the crisis, things have taken a turn for the better. Since the bottom in late March, not only has value performed better, but when it has been coupled with size (which has tended to magnify the excess return of value over the long-term), value has seen some significant outperformance.
For example, this chart shows the S&P 500 Small-Cap Value ETF against the S&P 500 over the past 6 months.
Obviously, the outperformance in this chart pales in comparison to the underperformance over the past decade, but at this point, those of us who are value investors will take what we can get.
One of my biggest weaknesses as an investor is that I sometimes get a little too optimistic. And the combination of the fact that value remains very cheap from a statistical perspective and this recent turn has got me thinking that the time for value to return to its past glory has finally come.
Although I certainly hope I am right about that, I have also learned that it is important to check my optimism and to always question myself the most when my optimism is at its highest. I did that a couple of years ago when I put together the best case against value stocks that I could come up with.
Based on the fact that I have learned a lot since I wrote that original article and that I am starting to see my optimism creep in again, I thought it would be a good time to update it and try once again to challenge myself.
Here is my second shot at a list of reasons why value investing may not work as well in the future as it has in the past.
 The Federal Reserve Has Changed the Game
I made this point in my initial article and I think it still holds true. You can argue that the Federal Reserve’s policies to artificially suppress interest rates could be a long-term headwind for value. Although the evidence about the relationship between the performance of value stocks and interest rates is mixed, in theory one would expect a lower discount rate to benefit longer duration growth stocks relative to shorter duration value stocks. And over the past decade, that is what has happened. Low rates also tend to move investors up the risk curve in search for return, which also could benefit growth over value. If you believe that the Federal Reserve policies of the past decade are the new normal, that may not be a good thing for value.
 Value Needs Recessions, And it Hasn’t Been Getting Them
When you look at the excess return of value over the long-term, one of the things that sticks out is that much of it has come in and around recessions. This chart from a 2016 article written by Ehren Stanhope of O’Shaughnessy Asset Management illustrates this point.
That isn’t necessarily a problem, unless of course we start to have less recessions. But that is exactly what has happened. Before the recent Coronavirus recession (which was so short it is hard to even call it that), we hadn’t had a recession since 2009.
This chart looks at all US recessions since 1923 (recessions are in red). It is pretty clear that there are more recessions on the left half of the chart than the right half.
If we are getting better at managing the economic cycle and are having less recessions, that could be bad for value since much of its outperformance comes around these periods.
 Value’s “Intuitiveness” May Be Its Downfall
I really like Larry Swedroe’s criteria for what makes a good investing factor. In his framework, a factor should be pervasive (work across different countries and asset classes), robust (work using different definitions), investable (work in the real world) and intuitive (make sense). That last one is where the issue may lie, though. The more intuitive a factor is, the more that investors will follow it. The more investors who follow it, the more negative impact that capital chasing it can have on its excess returns. Investors avoiding a factor is what leads to its premium. If when the factor is discovered it leads to more people following it than were avoiding it in the first place, you can end up with a situation where a positive premium becomes a negative one.
Adam Butler of Resolve Asset Management was on our podcast recently and he discussed this idea
In my original article, I also talked about the idea that less people may be abandoning value during its recent underperformance than have in the past. Using this framework, it becomes clear why that could be a bad thing since investors who adhere to a factor want the weaker hands to fold and withdraw their capital in order for the factor to sustain its positive long-term premium.
 Passive Investing May Have Broken the Weighing Machine
Ben Graham said that the market is a voting machine over the short-term, but a weighing machine over the long-term. What he meant by that is that even if the market doesn’t properly value a stock in the short-term, its fundamentals will eventually matter. But some argue that the flows into passive products have changed that reality. When investors add money to a passive fund, the fund will buy the constituents of the fund’s index at market-cap weights without considering their valuation. This can create a self-reinforcing situation where the largest stocks just keep going up, irrespective of their valuations. This obviously isn’t a good thing for value investors whose strategies are tethered to fundamentals.
Mike Green at Logica funds has been the leading proponent of this argument. This is an excellent interview with him that digs into the idea in more detail.
 Innovation Could be Leaving Value Behind
In my original article, I talked about the idea the value is short technology. Most value strategies have less exposure to technology than the market, and the technology stocks they do own are typically not the high growth names. If you are a believer that technology will continue to lead the market higher, this is a major problem for value.
But since I wrote the original article, I have learned that this idea is more nuanced than I thought. Even if you adjust for value’s bet against technology, it still doesn’t fully explain its underperformance, as value has underperformed across sectors.
Kai Wu of Sparkline Capital helped me better understand this when he came on our podcast. He used machine learning to better analyze what is going on with value and what he found is that value has been more of a bet against innovation than a bet against technology. If innovation continues to dominate our economy, and the stocks leading that innovation continue to lead the market, this issue will likely continue to be a problem for value.
The good news on this front is that in past technological revolutions, the less innovative firms have eventually figured out how to become more innovative and take advantage of the new technology. This has eventually led to improved relative performance from value. A similar situation could occur here.
The Future of Value
In my original article, I concluded by saying that I remained a big believer in value. If the two years since I wrote the article are any guide, I was certainly wrong about that as value has continued its long run of poor performance.
The hardest thing about looking at the other side and challenging your beliefs is that if you still believe the same thing coming out of the process as you did going in, then it is very difficult to evaluate the success of what you have done. So as someone who remains a believer in value, I can’t say if I have given enough consideration to the arguments above. I can say that I think all of them have merit and all of us who are value investors should be thinking about them and how they might impact the way we invest money going forward.
Even if this process hasn’t changed my opinion, I think it has been a valuable one and it is one I will continue going forward. So you can look forward to an updated case against value stocks in a couple more years. Hopefully for those of us who run value strategies I will be writing it after a better two years for value than what we have seen since my first article.