Has the market become so efficient that the time has come to abandon value index funds? Information is more widely available now than ever, and the resources dedicated to processing and acting on it have never been greater. As a result, significant mispricing is less likely now than in the past. Yet despite these advancements and value stocks’ lengthy stretch of underperformance, it’s premature to give up on value index investing.
Is Value Investing Broken?
Value stocks have been out of favor for a long time. The Russell 3000 Value Index has lagged the Russell 3000 Growth Index by a staggering 5.9 percentage points annualized from the end of 2006 through May 2020. That’s enough to try almost any investor’s patience. It’s the longest stretch of underperformance U.S. value stocks have ever experienced.
The world has changed over the past few decades in ways that critics of value investing argue reduce its efficacy. Among these changes: 1 | Intangible assets and share buybacks have grown in importance. Firms that are more reliant on either of these things may look artificially expensive on price/book, as book value doesn’t capture internally developed intangible assets and share buybacks reduce book value. 2 | Interest rates are much lower now than they were before the global financial crisis, which some have argued creates a headwind for value stocks. 3 | As awareness of the value effect has grown, more investors have incorporated it into their investment decision-making, which could reduce its efficacy.
Other criticisms are evergreen and point to the fact that simple valuation metrics are incomplete and say little about intrinsic value, which is unobservable.
The Case for Value Is Still Strong
AQR recently published a paper debunking many of these arguments.1 (This firm uses value in many of its strategies.) The authors looked at valuation measures that attempt to correct for perceived accounting deficiencies. But even with those adjustments, value still underperformed. This suggests it is unlikely that intangible assets or conservative accounting choices are driving value’s underperformance. They also concluded that share repurchases didn’t have a big impact on value’s performance.
Similarly, it isn’t clear that low interest rates disproportionately hurt value stocks, despite that argument’s intuitive appeal. The thinking is that growth stocks’ cash flows are further out in the future than value stocks’, so they have longer duration and should benefit more from falling rates. However, unlike bonds, stocks’ cash flows aren’t fixed. They tend to contract during recessions (which is when rates tend to fall) and grow during expansions. On top of that, the equity risk premium tends to be procyclical. So, changing interest rates don’t have a straightforward impact on the relative performance of value and growth stocks. Indeed, another paper from AQR found there was no significant relationship between the level of interest rates and the performance of an industry-neutral long-short value portfolio.2
Interest rates could have a disproportionate effect on certain value-leaning sectors, but it isn’t clear that falling interest rates are a net negative for broad value portfolios. For example, low spreads between long- and short-term rates tend to hurt banks. However, low interest rates tend to help utilities and real estate investment trusts, which are highly leveraged and have more stable cash flows than most.
The factor crowding argument also doesn’t do much to explain why value has underperformed. If it were at work, we would expect to see valuations between value and growth stocks compress. Instead, they have widened considerably over the past decade.
It’s harder to dismiss the argument that simple valuation ratios don’t say much about where a stock is trading relative to its intrinsic value. Each stock’s intrinsic value is determined by the present value of its future cash flows. That, of course, is unobservable. What we see instead are prices relative to metrics like book value, sales, or earnings. Yet none of those paints a reliable picture of long-term cash flows.
Requirements for Value Investing to Work
Despite their flaws, simple valuation ratios can point to higher expected returns if investors either 1 | systematically underestimate the cash flows of stocks trading at low valuations (and overestimate how well pricier stocks will do) or 2 | apply higher discount rates to the cash flows of stocks trading at lower valuations as compensation for risk.
Both effects likely contributed to the historical success of value investing. Given the difficulty of forecasting long-term cash flows, it’s easy to understand how investors might extrapolate their near-term expectations too far into the future.
However, it’s a good bet that mispricing will be less pronounced going forward than in the past, as markets have become increasingly competitive and information more widely available. These improvements should reduce systematic pricing errors arising from behavioral biases.
That doesn’t mean value investing is dead. There will likely always be some mispricing, though there’s no risk-free way to exploit it. However, the payoff to value stocks will probably behave more like a risk premium going forward.
In part 2 of this article, we will continue to discuss the risk of value investing and look at why value has underperformed.
1 I srael, R., Laursen, K., & Richardson, S. 2020. “Is (Systematic) Value Investing Dead?” AQR Capital Management. https://papers.ssrn.com/sol3/papers.cfm?abstract_ id=3554267
2 Maloney, T., & Moskowitz, T. 2020. “Value and Interest Rates: Are Rates to Blame for Value’s Torments?” AQR Capital Management. https://papers.ssrn.com/sol3/ papers.cfm?abstract_id=3608155