Value investing is dead. Long live value investing. 💫

 

Value investing is the discipline of buying securities at a significant discount from their current underlying values and holding them until more of their value is realized.

The element of a bargain is the key to the process.

: Seth Klarman

 

 

Value investing is one of the oldest documented investing style. It has been around for decades. Some of the most famous long-term investors, Warren Buffet to S Naren, identify themselves as value investors.

For the uninitiated here is a simplistic sidenote on what is a value stock? Say a company has a market cap of Rs 100 Crores based on the current market price. Your analysis looking at the companies assets, liabilities, current and future prospects and at other companies in the same industry leads you to value the company at Rs 200 Crores. You have a “value” investment in your hand now – you can buy the company at Rs 100 Crores market cap and wait for it to reach your calculated value of Rs 200 Crores and then sell it at a handsome profit.

 

From the above example, a few things fall out immediately.

1/ Price (i.e the Rs 100 Crore market cap) is given and observed by everyone from the market.

2/ Value, however, is subjective. A company that one investor values at Rs 200 Crores based on their methodology could be valued at Rs 50 Crores by another using a different methodology.

3/ There is no guarantee that the market will come around to your viewpoint and that the market cap of the company will increase to Rs 200 Crores.

4/ Even if the market cap rises to Rs 200 Crores it may take a long time for the value gap to be realized. This is the classic ‘the market can remain irrational longer than you can remain solvent’ saying attributed to Keynes.

 

 

In the latter half of last century value stocks were one of the leading sources of fund manager alpha. Fundamental value managers would focus on buying value stocks right before they repriced by looking at triggers, while quantitative value managers would create valuation filters (P/B, P/E etc) to identify pools of value stocks. Value investing seemed to never go out of fashion and it also worked everywhere with the possible exception of Japan. Believers would say they had found the secret sauce for beating the market.

 

The methodology continued to be refined with small-cap value finding favour through the 80s and 90s after the small-cap effect was first documented by Rolf Banz. Fama & French popularized a quantitative measure of value investing that made it easy for almost anyone to practice it. What is hard about buying the lowest price to book stocks in a given industry? Anyone with decent data and a spreadsheet could do that. And they all did, driving a lot of investors into this style. Value investing became less “contrarian” and more “mainstream”.

 

At the turn of the century value investing hit a snag maybe because it became so popular. As more and more investors pile on into a strategy the returns from that strategy tend to moderate. Returns to the value factor and even the small-cap value factors have been diminishing since then. Practitioners have to keep on modifying there core tenets of what constitutes a value stock to derive any value from value investing 🙂

 

And of course value investing has completely missed the mega-cap tech rally after the 2008 financial crisis.

 

How bad is it? In the chart below we look at Vanguard growth ETF vs Vanguard value ETF.

 

 

This has been the longest and the most severe underperformance of value investing compared to growth investing. But what about the value alpha i.e excess returns gained by investing in value over the index.

 

 

There has been no excess return either.

 

No wonder value investing style is falling out of favour with both old and new investors.  However, by most metrics value investing has never been more attractive for expected future returns. In a very simplistic sense value investing is a “reversion to mean” kind of strategy. The thinking is that investors massively overreact to bad news about firms out of favour or facing difficulties and drive their prices way below what the firm’s assets are worth. Over time the news flow moderates, the future turns out less bleak than predicted and the stock price of these firms bounce back.

 

Right now everyone is focused on mega-cap tech and it is likely that the rally in growth stocks will get overdone as well – the pendulum swings both ways. This month we saw early signs of some strategy rotation. Value and especially small-cap value outperformed both the index and the growth strategy by a large margin after a very long time. Of course, one swallow does not a summer make. But given how stretched the outperformance is for growth stocks over value stocks the odds of getting better returns in value are as good as they have ever been.

 

Ps: we have used examples from the US market, but the prolonged value underperformance has been universal including Indian stocks. 

 

Happy investing,
Gaurav
CEO | kuvera.in | @rustapharian

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