Now Is The Time For Value To Outperform Growth
February 1, 2016
by John Alberg and Michael Seckler
In his book, The Dhandho Investor: The Low–Risk Value Method to High Returns, Mohnish Pabrai coined an investment approach known as "Heads I win; Tails I don't lose much." Q3 2021 hedge fund letters, conferences and more The principle behind this approach was relatively simple. Pabrai explained that he was only looking for securities with Read More
We believe that now is a very attractive time to invest in value strategies. In similar times in the past, value investors achieved both strong absolute returns and robust relative performance versus the broad market indexes. Let’s explore what history can teach us about what is to come.
Our confidence comes from using machine learning to study the history of public companies and their market values. Over the past 50 years, abundant evidence shows that it would have been fruitful to buy companies that were priced very low in relation to their earnings. Moreover, our own research suggests that this has particularly been the case for companies that also have a combination of consistent operations, good returns on capital and balance-sheet strength.
However, during recent years, our strategy has produced below market averages. These results have come during an extended period of growth stocks outperforming their out-of-favor value counterparts. In this context, the S&P 500’s performance has been driven by a small number of companies. The index’s two best performers of 2015 were Amazon (+118%) and Netflix (+134%), with price-to-earnings ratios of approximately 900 and 300, respectively. It is no surprise that a value-oriented strategy would miss these recent gains.
There are other unusual – and unsustainable – aspects of this current market. Joel Greenblatt, a prominent member of the “buy good companies at good prices” school of investing, shared the following observations in a September 2015 note to investors:
Buying only those companies that lose money has earned investors anywhere from 20% to 50% over the last twelve months.
This is the first time since the late 1990s that over 80% of IPOs are losing money.
Buying the top momentum stocks and shorting the bottom momentum stocks (from the Morgan Stanley momentum index) would have achieved positive 18% returns so far this year whereas buying the top value stocks and shorting the bottom value stocks (from the Morgan Stanley value index) would have lost 13%.
These observations should give all investors pause. If you have not been participating in the market’s recent gains, should you pivot your investment process based on what has recently worked in the markets? Here are three reasons why we believe the answer is no:
- Companies derive their intrinsic value from their ability to generate cash. It is, therefore, speculative to invest in companies that have not yet demonstrated an ability to consistently deliver earnings.
- Across long periods, abundant evidence suggests that getting the most earning power for your dollar has been the key to investment success.
- Following periods when buying companies on sale has fallen out of favor, value strategies have consistently reasserted themselves through strong absolute and relative performance. We will clearly illustrate this point in the charts that follow.
Let’s dig into these points to understand why we believe now is the time to add capital to value strategies.
Refresher on the long-term performance of systematic approaches to value investing
Below are simulated results, which show the annualized performance by decade of four simple value-oriented approaches for selecting equity investments.
The results are compelling. The simulations reflect investing in inexpensive companies, where inexpensiveness means being among the cheapest 10% of all companies as ranked by a respective value factor. Clearly, a good route to realizing above-average returns would have been adhering to a process — even a very simple one — of buying companies at low prices in relation to their sales, book values or earnings.
Yet, as we will see, achieving these returns over the long run requires enduring periods where buying inexpensive companies does not yield good results.
Although value investing has performed well over the long term, it is also clear that it has not performed well all of the time. The charts that follow represent one of the most widely researched approaches to value investing, where a value stock is defined as having high book-to-market equity. We will look through two lenses at the cycles value investors have endured along the way to superior returns. The first relates to how value investing has performed versus the S&P 500 market index. The second relates to how it has done versus growth stock investing.