Is There Still Value in Value Investing?
Dr. Jan-Carl Plagge, Head of Applied Research
On Oct. 24, news channel CNBC obtained a client letter by renowned value investor David Einhorn in which he questioned the viability and effectiveness of value investing after years of underperformance.1
The world may be in the midst of a systemic shift, Einhorn posited, toward a system where a company’s disruptive power, innovative drive and contributions to social change may be better predictors of its stock price than its financials.
Such a stringent rebuke must be put into context. Value investing – the purchase of stocks that are underpriced relative to their fundamental worth – has amassed positive returns since the global financial crisis. Nevertheless, there is a lot of the disappointment with the style, mainly stemming from its underperformance to so-called growth stocks, a diametrically opposed strategy that favors buying expensive stocks with higher-than-average earnings prospects.
In the U.S., the Russell 1000 Value Index has posted annualized returns of 6.89% in the past ten years, compared with a 10.1% annual return for the Russell 1000 Growth Index. The performance gap has widened this year, with the Growth index jumping 28% and Value rising only 6.9%.
As uncertainty pervades, we look at the origins of value investing, and try to assess if there is still value in the strategy.
Slow and steady wins the race
Professor Benjamin Graham laid much of the groundwork of value investing in the seminal 1934 publication Security Analysis,2 written with David Dodd. A famous student of Graham’s who pursued the strategy to great effect is Berkshire Hathaway’s Warren Buffett.
Value investing contains several assumptions: markets are not information-efficient; solid fundamentals will win out in the end; and prices will eventually catch up with a company’s true value.
A matter of definition
To analyze the virtues of a value strategy, a lot depends on how it is defined. The metrics used to determine fundamental worth have evolved and are still a subject of debate.
Graham and Dodd used a price-to-earnings ratio while another popular model created by Professors Kenneth French and Eugene Fama relies heavily on book-to-market ratios.3 In both cases, lower ratios denote desirable buys.
STOXX’s value factor strategies
STOXX’s comprehensive factor index suites offer value strategies for two regions: the iSTOXX® Europe Value Factor Index and the iSTOXX® USA Value Factor Index.
Both indices use a composite of two measures to rank stocks: forward 12-month earnings yield and cash-flow yield. If either measure is negative, it is replaced by cash flows from operations over total assets.
However, the Value Factor indices do not replicate a pure value strategy. They are optimized and designed to stay within a 3% tracking error of the chosen benchmark and are subject to additional constraints to reduce country and industry bias relative to the benchmark.
Beating the market
Chart 1 shows the performance of the iSTOXX Europe Value Factor Index and the iSTOXX USA Value Factor Index relative to their respective benchmarks, the STOXX® Europe 600 Index and STOXX® USA 900 Index.
The chart shows that the value factor has actually outperformed the market by at least 30 percentage points in the period.
When value is in favor
The value premium – like all factor premiums – is subject to variability and cyclicality. There are periods where value has outperformed significantly – particularly following recessions and bear markets, where the most depressed parts of the market are the ones that rebound most strongly.
In the first year of the bull market that followed the global financial crisis, the iSTOXX Europe Value Factor Index jumped 93%, comfortably beating the 68% advance for the STOXX Europe 600.
Thinking beyond the bull market
Christopher Geczy, academic director of the Wharton Wealth Management Initiative, points out that current growth stocks’ outperformance is strongly driven by a small number of technology companies.4 This may play a role as the bull market turns eight years old, raising doubts on the air left for such an unusually long rally and its key beneficiaries.
In the event of a pullback, valuations are likely to play a role. The iSTOXX Europe Value Factor trades at 12 times its constituents’ expected profits, while the STOXX Europe 600 is valued at 16 times earnings.
A tool for diversification
In any market environment, a value strategy promises to be a good tool for diversification in a multi-factor strategy, such as represented by the iSTOXX® Europe Multi-Factor Index. In this context, the value factor is found to be the least similar among six factors, with an average correlation to all other factors of just 0.23. Thus, in a portfolio exclusively based upon factor indices, the value factor has the highest diversification potential.
For now, there is still value
When assessing value’s performance, it is thus vital to consider not only cyclicality but also sector allocation. Growth stocks are not enjoying an across-the-board rally but are driven by outsized gains in the tech industry.
With industries such as technology on the rise, we may have to listen to Mr. Einhorn and be prepared to re-think what constitutes a company’s intrinsic value. For the record, Mr. Einhorn later qualified his critical remarks about value investing by saying that the strategy would make a comeback “at some point.”5
In the meantime, there may still be value in value investing – especially as part of a well-rounded multi-factor strategy.
iSTOXX® Europe Value Factor Index
iSTOXX® Europe Multi-Factor Index
iSTOXX® USA Value Factor Index
STOXX® Europe 600 Index
STOXX® USA 900 Index
Factor Investing is Smart Investing
Factor Market-Neutral Indices: Accessing Pure Risk Premia
1 ‘David Einhorn: Value investing may be dead and Amazon and Tesla killed it,’ CNBC, Oct. 24, 2017.
2 Graham, B. and Dodd, D. (1934). Security Analysis.
3 Fama, E. F. and French, K. R. (1993). Common risk factors in the returns on stocks and bonds. Journal of Financial Economics, 33, 3–56.
4 ‘Is Value Investing Really in the Doldrums?,’ Knowledge@Wharton, Nov. 3, 2017.
5 ‘David Einhorn says value investing will make a comeback, just like it did after dot-com bubble,’ CNBC, Oct. 25, 2017.