Disciples of value investing have had their faith tested in recent years, with growth stocks largely outperforming their value counterparts since the 2008 financial crisis.
Research from the Brandes Institute, however, indicates such periods of underperformance are few and far between, and the coming years are likely to be kinder to investors who opt for cheap, unloved stocks over high-flying glamour companies.
Value investors like to boast that the tortoise really does beat the hare when it comes to investing. Fashionable glamour stocks with high valuation multiples might occasionally outperform, they say, but cheap, unloved stocks tend to deliver over the long term.
However, lengthy periods of underperformance can occur, as a recent Brandes Institute paper shows. The firm, a research division of global value investing firm Brandes Investment Partners, notes international large-cap glamour stocks easily outperformed large-cap value stocks between June 2005 and June 2010. They repeated the feat in the five-year periods ending in June 2011 and June 2012, while there has been little difference between the two approaches in the subsequent five-year periods ending in mid-2013 and mid-2014.
This has been “the longest stretch of weak relative performance over the 34 years for which we have studied returns”, the paper notes.
Stratospheric valuations
So is value investing dead? Perhaps, although the same thing was suggested in the late 1990s when investors rushed out of boring blue-chip stocks and into dotcoms sporting stratospheric valuations.
Warren Buffett's Berkshire Hathaway almost halved in price between March 1999 and March 2000, even as the broad market surged to record levels, prompting the great value investing icon to be written off as yesterday's man. "What's wrong, Warren?" was the headline in Barron's in December 1999, in a piece that suggested Buffett "may be losing his magic touch". Within three months, the Nasdaq crash had begun. Over the next five years, value names beat glamour stocks, outperforming by an annualised 50.6 per cent.
While that level of outperformance is atypical, studies confirm value investing generally pays better than growth investing. A famous 1994 study found that between 1968 and 1994, value stocks consistently and easily beat growth stocks in the US. The cheapest decile of stocks, as measured by their price-book ratios, returned average five-year returns of 19.8 per cent, more than double that of the most expensive names. It didn’t matter what valuation metric was used, the researchers noted: value always won out.
This phenomenon is not confined to the US. In fact, it is even more evident in Europe and in emerging markets, according to the Brandes Institute. Between 1980 and 2014, the value premium in non-US developed markets was almost double that seen in the US, it says, while the value effect in emerging markets was three times as strong. Nor did it matter what valuation metric one used or whether one invested in small-cap or large-cap stocks; in all cases, value stocks trumped growth stocks, and they did so consistently, dominating in “all but one five-year period from 1985 through 2009”.
Why? The most logical explanation – one put forward by value investing legend Benjamin Graham as far back as the 1930s, and by behavioural finance experts in more recent years – is that investors tend to overreact to both good and bad news. This results in promising growth companies being bid up to unrealistic levels, and troubled firms being (often wrongly) left for dead. Another Brandes study, The Role of Expectations in Value and Glamour Stock Returns, found glamour stocks (unsurprisingly) fall when they miss earnings estimates.
However, the same paper noted value stocks tended to rise in price when they miss estimates, even if business fundamentals deteriorated. This suggests value stocks’ superior returns “may not be a result of positive developments relative to expectations but instead are more likely due to a gradual and corrective reversal of earlier overreaction and mispricing”.
‘Excellent’ companies
Other studies add weight to the idea that stocks habitually become overpriced and underpriced. One such study was inspired by
In Search of Excellence
, the best-selling 1982 book that examined the US’s best-run companies. The study compared the subsequent five-year performance of the “excellent” companies to a basket of “unexcellent” stocks and found the latter outperformed the former by 11 percentage points annually.
Countless other studies confirm that over the long term, cheap stocks invariably beat expensive glamour stocks. This is well known, and yet investors everywhere continue to be seduced by expensive stocks. Why? Money manager, author and blogger Patrick O’Shaughnessy describes such firms as lottery stocks, in that they offer the remote but real promise of huge returns. Investors are invariably tempted by high-profile stocks such as electric car-maker Tesla, which has soared by more than 1,000 per cent over the last three years despite concerns over its valuation.
Growth investors
Since 1963, O’Shaughnessy notes, the best-performing decile of glamour stocks in any given year have delivered enormous returns; on average, they outperform the market by 115 per cent over a 12-month period. The problem is that only a select few deliver on their promise; the median glamour stock underperforms the market annually by 11 per cent, according to O’Shaughnessy’s data. Additionally, the worst decile gets butchered, underperforming by 75 per cent.
In contrast, while some value stocks also get walloped, the average ones outperform the market.
Like buyers of lottery tickets, growth investors focus on possibility, rather than probability. “Over and over again, we are seduced by the possibility of earning huge excess returns and blinded to the probability that we will underperform the market. Probabilities are boring, possibilities are exciting. But probabilities are all that matter in an uncertain world,” O’Shaughnessy writes.
Recent years, as noted earlier, have departed from the script, mainly due to the hammering suffered by European bank stocks in 2008 and in 2011-12. Financials, as investors in Irish bank stocks know all too well, turned out to be a huge value trap, and their underperformance dragged down the returns of value investors. However, although the performance of value stocks over the last five years may appear underwhelming, the tide may already have turned in their favour. The cheapest value stocks “outpaced their glamour brethren by double digits in each of the 12-month periods ending in June 2013 and 2014”, notes the Brandes Institute, neutralising the “unusually bad” returns of 2011 and 2012.
Few bargains
Many investors have complained there are precious few bargains in the US market, but the international picture is different, according to Brandes. It says there have been only three other periods since 1980 when the cheapest non-US large-cap stocks were as attractively valued as they are today. In the five years following each of these periods, such stocks averaged annual returns of 21 per cent, it says.
Money managers, too, are enthusiastic, with recent Merrill Lynch monthly fund manager surveys showing a large majority expect value to outperform growth in Europe over the next 12 months.
Glamour stocks have defied the doubters in recent years but might their unusually long period of outperformance be over? History, momentum and valuation all suggest the coming years may finally reward patient value investors.
