Value Investing Is Not Dead

Value investing was described as “losing its effectiveness” by The Wall Street Journal on Monday. The article was published approximately two months after Goldman Sachs issued a report entitled, “The Death of Value?”

A quick glance at the recent numbers shows why such commentary is being written. For the 10-year period ending June 30, 2017, the iShares S&P 500 Growth ETF (IVW) has bested the iShares S&P 500 Value ETF (IVE). The annualized returns for the two funds are 8.8% and 5.1%, respectively. Among small-cap stocks, growth is also beating value. The iShares Russell 2000 Growth ETF (IWO) has a 10-year annualized return of 7.9% versus 5.8% for the iShares Russell 2000 Value (IWN).

The numbers don’t lie, but Wall Street is often short-sighted. Long-time value investors with good memories should be feeling a strong sense of déjà vu right now. In the late 1990s, value fund managers were struggling to hold onto their jobs. Even Warren Buffett found himself having to defend his strategy. Shifting forward to 2017, long-time value stalwart Jeremy Grantham of asset management company GMO cautioned in his first-quarter commentary, “Investors—value managers included—should brace themselves for continued higher multiples than those of the old days.”

Grantham’s commentary was viewed as a proverbial white flag being flown by the value camp. The reaction was eye-raising enough that Grantham felt obliged to respond. After starting a June 29 note with “After a few misquotes and misunderstandings by journalists,” he clarified his observation about the current state of value by opining, “We should be braced for a long-drawn-out and painful flight path back toward the old ratios we know so well. As a value manager, I wish it were not so.”

Between the headlines and Grantham’s expectations for valuations to stay above their historical averages for the foreseeable future is the reality that value often lags growth on a short-term basis. Large-cap growth has outperformed value 28 times on a calendar-year basis between 1946 and 2016. It just so happens that five of the 28 wins for growth have occurred since the end of the 2007-2009 financial crisis. If we extend the look-back periods to just after the end of the 1990 bear market, growth has beaten value 13 times. In other words, nearly half of all the post-World War II calendar-year wins for large-cap growth have occurred during the past 26 calendar years.

Of course, value’s win rate over the past 26 years is still 50%. More importantly, value beat growth in terms of overall returns. The annualized gain for large-cap value between 1991 and 2016 was 11.0%, versus 10.4% for large-cap growth. If we go back to 1946, the return differential becomes even more favorable for value. Since the end of World War II, value has gained 13.2% on an annualized basis versus 10.3% for growth. Going even further back to 1927, the returns are 12.0% for value versus 9.4% for growth. Thus, history is on value’s side. (The historical return data is from Dartmouth professor Kenneth French’s online database.)

To assume value’s relative weakness over shorter periods is a sign that it no longer works is to assume human behavior has evolved to the point where investors are correctly pricing growth stocks. This would be a big assumption, and one that value adherents would likely want to take the other side of the bet on. While highly valued stocks can become even more overvalued for a surprisingly lengthy period of time [e.g. Amazon (AMZN)], eventually their prices will come down. The reason why value works over the long term is that investors overpay for perceived good growth prospects, while underestimating the likelihood for companies with perceived lackluster or poor growth prospects to do well. This ongoing fact means that sooner or later value will again be back in vogue—something even the author of the aforementioned Goldman Sachs reports expects.