100% Value Stocks: Why What Looks Good On Paper May Not Be Great For Real Life by GersteinFisher
In the world of quantitative investing, value strategies have been a dominant focus since Eugene Fama and Kenneth French published their seminal paper on the three-factor model in 19931. Companies with low Price-to-Book ratios (value stocks), the research demonstrated, entailed extra risk as compared to those with higher Price-to-Book ratios (growth stocks), and thus investors required extra compensation for holding them. (The other two factors in the three-factor model were market, or the risk associated with investing in equities as compared to “safer” assets like Treasury bills; and size, or the risk of owning smaller-capitalization stocks versus their larger-cap counterparts.)
Quantitative strategies based on the value factor have grown in popularity in the ensuing years. At Gerstein Fisher, we embrace value-based investing; historically, value has performed very well. Exhibit 1 shows the growth of $1 invested in both a 100% value index and a 100% growth index from July 1926 through October 2015. As Exhibit 1 shows, an investor would have been far better off investing in only value over this 89-year period. But who has an 89-year investment horizon?
Let’s also ask ourselves why value performed better. It is generally accepted that risk and return are related. The argument for investing in what we at Gerstein Fisher call “rewarded factors”, such as small cap and value, are largely risk-based: simply put, investors require extra compensation for holding assets that are riskier than the alternatives – small caps, over long periods of time, should outperform their larger-cap counterparts, and value should outperform growth because these investments carry greater relative risk.
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But there’s a fundamental problem with simply holding a portfolio of 100% value stocks: it is not a realistic expectation since investors are human beings (and not computers or robots) with emotions like fear and greed. If an individual is invested in an all-value portfolio and, as has been the case over the past nine years, growth has actually been outperforming, he may start to question his strategy. He may even panic and sell out of his value stocks and buy growth stocks. Investment-style cycles have been pronounced, but our research has shown that such attempts to time markets and cycles are far more detrimental than beneficial to individuals’ long-term wealth accumulation.
So going back to our study in Exhibit 1, what would happen if instead of all-value or all-growth portfolios, there was a third option – a portfolio combination that combined value and growth together in equal proportions? The results of this are shown in Exhibit 2 below.
Over the period, the 50/50 portfolio outperforms the growth-only portfolio by a significant margin. Again, we should point out that we are examining a time frame that is not a realistic investment horizon. So we decided to look more closely at growth and value over various time periods within this wider date range and evaluate how often one outperforms the other, and how often an investor would be better off owning both.
Analysis and Results
For our value, growth and blended portfolios, we used the Fama French Large Value (ex Utilities) Index, the Fama French Large Growth (ex Utilities) Index, and a 50/50 mix of both, respectively.
An overview of the results of our analysis is presented in Exhibit 3.
Comparing the three portfolios over short periods of time (less than 5 years), our research shows that it is essentially a coin-toss game as to which outperforms; in other words, there is an almost equal probability that any of these is the winner. Additional observations:
- When comparing the Value and 50/50 portfolios for the periods in which the 50/50 portfolio is not the winner, its underperformance as compared to Value is significantly lower than Growth’s underperformance as compared to Value.
- The same holds when Growth and 50/50 are analyzed. It is a coin-toss game, and when the 50/50 portfolio underperforms Growth it does so by less than Value.
Over long investment periods (10 years or more), clear winners emerge and different “pure” portfolios (Value only or Growth only) outperform in different regimes. It is no longer a coin-toss game:
- Jul. 1926 to 1944: Growth wins
- 1945 to 1962: Value wins
- 1963 to 1980: Value wins
- 1981 to 1998: Value wins
- 1999 to Jul. 2015: Growth wins
To summarize, if you had about a century for your wealth to compound, a value-only strategy would be a sound investment. Even over 50 years, value would likely have performed best. Over shorter periods, however, it’s not as clear which of the three approaches will win out, but our analysis shows that blending Growth and Value even in a simple 50/50 split generally offers more stable returns than either a 100% Value or 100% Growth portfolio. Additionally, investors holding either pure-Growth or pure-Value portfolios have to contend with the inevitable swings of their investment style going in and out of favor. Behaviorally, it is difficult to “stay the course” when you see your strategy losing ground day after day, week after week – even year after year. Thus, a diversified approach that blends the two styles would appear to be a superior approach for both empirical and behavioral reasons.
Finally, if combining value and growth is good, we would argue that combining multi-factor value and multi-factor growth strategies has the potential to be even better. While factor-based approaches to domestic growth equity are much less prevalent than their value counterparts, they do exist and, in our view, are an improvement upon traditional growth equity approaches.