Trying to Put the Struggles of Value Investing in Context

By Jack Forehand, CFA (@practicalquant) —

Value stocks have struggled for a long time now. Although the degree of underperformance can vary significantly based on the metric you use and the universe you apply it to, there is no question that the past decade has been a bad one for value investing. And the past five years have been even worse.

I have always been a big believer in value, but it is only natural for all of us to question an investment strategy that struggles for this long. These types of extended periods where an investment approach doesn’t work can be the most dangerous ones because they are when our biases and emotions make sound decision making the most difficult. The pressure inside of us to make a change when something isn’t working is very strong and gets stronger the longer things don’t go our way. This leads many investors to abandon a strategy at exactly the wrong time. But on the other hand, other investors will get so entrenched in their beliefs that they won’t see the other side, even when it becomes obvious.

When I have a high level of conviction in something, but want to make sure I am giving that conviction sufficient scrutiny, I have found that two things are the most helpful.

  1. Make a written case against what I believe (I did that here)
  2. Seek out the opinions of the smartest people I know on the topic (making sure to include both people who agree with me and those who don’t)

Over the past few months, I have done both of those with respect to my belief in value investing and I wanted to share some of my thoughts following that process.

One of the most important things I have learned about difficult issues in investing is that there is rarely one correct answer, so I certainly don’t pretend that I have found the answer and can share it here. But I have been able to refine my thought process and get a better understanding of the big picture.

Here are a few of the conclusions I have reached.

The Academic Argument for Value Still Holds

In my opinion, the first step in any process of looking at whether value still works needs to start with why it worked in the first place. If you look at the academic research, there are two reasons that are cited for why value works. The first is that value stocks are riskier, and with excess risk comes excess return. The second is that there is some degree of mispricing that goes on. Companies whose stocks trade at a discount to the market typically have significant problems in their businesses and investors tend to systematically overestimate those problems. This provides an opportunity for patient investors who buy a basket of value stocks and can wait for the mispricing to correct itself over time (and wait is certainly the operative word in the past decade because it has taken a really long time).

So the first question to consider in looking at whether value still works is whether these two supporting arguments still hold.

With respect to the first argument, it is hard to argue that value stocks have become less risky. They continue to exhibit volatility in excess of the market and they continue to have extended periods where they underperform. It is difficult to make the case after a decade of underperformance that value stocks have lost their edge because of reduced risk.

It is also hard to argue that the mispricing argument is no longer valid. The way human beings are wired hasn’t changed, which means we are still going to overreact to bad news. And investment managers also still face the same career risk they always have. If they underperform their benchmark for too long, they will still get fired.  

So, in my opinion, nothing has changed with respect to the academic arguments supporting value that would lead to the conclusion that it no longer works. 

We Have Seen This Before

Another important thing to look at when any investment strategy struggles is whether what is going on has happened before and if so, what happened after it. In the case of value investing, decade long periods of underperformance have occurred several times before.

This chart from Larry Swedroe illustrates this concept. It looks the percentage of time that each factor underperforms over various periods.

As the chart shows, the value factor has underperformed in 14% of ten-year periods historically. In other words, in a historical context, the current decade, while not common, is something that value has experienced before.

The chart below illustrates a similar idea graphically.  It looks at the difference in returns for value vs. growth over 10-year rolling periods.

The fact that the line is above zero most of the time shows that value typically outperforms growth. But there are three major exceptions: The Great Depression, the dotcom bubble and the current market.  In the previous two cases, value investors were handsomely rewarded for staying the course during the down periods. So what we are seeing now is not unprecedented and the historical evidence we do have shows that value has bounced back in previous instances. Those are both positive things.

Timing the Turn is Impossible

Another thing that history teaches us is that trying to time the turn in something like value is essentially impossible. The fact that value has underperformed for a decade doesn’t tell us anything about what it will do this year. If history is any guide, it does tell us that the odds that the next decade for value will be much better than the current one are very good, but there is no relationship between the length of an underperforming period and short-term results going forward. Mean reversion is a very powerful concept in investing, but it is much more useful in the long-term than the short-term. Even if value underperforms for another decade, that won’t provide us with enough information to say with any significance whether a short-term turn is near.

The Chances Value Investing Doesn’t Work Anymore Are Not Zero

One of the things that struck me most when I wrote the article that made the case against value investing is that some of the arguments are actually pretty strong. I think its possible that big data and AI are going to make traditional value investing much more difficult. I also think the fact that value typically makes an explicit bet against technology by underweighting the sector (or at least the highest growth names within it) and an implicit one by owning many of the firms that technology firms like Amazon are replacing is a problematic one. Value has also tended to do better when rates and inflation are higher. If quantitative easing is going to keep rates low for a long period of time, that could be a significant issue for value.

I don’t say all of this because I have lost my belief in value. Despite looking at the other side, I remain a believer and continue to stick with the strategy. I say all of this because there is certainly a plausible scenario where the turnaround that all of us that believe in value are calling for doesn’t materialize or takes much longer to arrive than we think.

If there is one thing I have learned in investing, it is that almost nothing is certain. To get returns, you need to bear risk. And if there was certainty about value stocks coming back, there would be no risk.

Bringing it All Together

Where does all of this leave me in terms of my belief in the future of value investing? The best answer I can come up with is cautiously optimistic. I think the risk and mispricing arguments in favor of value still hold. I am a big believer in base rates and I like what history says about buying value stocks during periods like this. But I also recognize that I have no ability to time the turn and I recognize that a bounce back in value is not a certainty, no matter how hard I try to convince myself it is. I also recognize that some very smart people disagree with me on this and I need to continue to read and understand their arguments as much as possible to combat my own confirmation bias.

So if you were looking for a definitive take on the future of value, you won’t get it here. But I certainly have learned a lot studying the issue and I am confident that will make me a better investor going forward.

Copyright: Photo Credit: / feelart

Jack Forehand is Co-Founder and President at Validea Capital. He is also a partner at and co-authored “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies”. Jack holds the Chartered Financial Analyst designation from the CFA Institute. Follow him on Twitter at @practicalquant.