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[1]:
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.[2]
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.
Market cycles
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.
Value vs. the S&P 500 index
Since 1962[3], a hypothetical portfolio based on this value approach[4] would have grown almost 10-times more than the same money invested in the S&P 500. Yet, while this form of value investing would have done exceptionally well over the long run, it has performed poorly during recent years. So, perhaps the right question to ask is if value investing still works.
You might have asked that same question in 1966, 1973, 1980, 1991, 1999, 2003 and 2009. At those times, the same value approach behind the returns described above would have underperformed the S&P 500 for multiple years, in some cases by more than 30%. The chart below illustrates this point. The top section shows the hypothetical cumulative returns of the value approach versus the S&P 500 total return (i.e., price appreciation plus dividends) between 1962 and September 2015. The bottom section of the chart shows the drawdowns of the value approach relative to the S&P 500.[5]
Clearly, value investing has endured many long periods of underperformance despite its long-term success. In fact, we are currently in the midst of such a period. But what happens when these periods end? To answer that question, we plotted the two-year hypothetical return of this value strategy starting from the bottom of the six largest relative drawdowns experienced prior to the current one.
While it may seem obvious that the relative returns of this value strategy might be strong once its relative performance turned around, the charts also show that strong absolute returns have been realized in each value recovery.
Value vs. growth investing
The previous charts show how value investing has performed versus the S&P 500 market index. The graphs that follow examine the cycles involved in buying inexpensive (VALUE) companies versus expensive (GROWTH) companies. We shared this analysis earlier this year and have updated it with data through November. We believe this lens remains particularly relevant, as we are currently in the midst of the longest period of growth stock dominance since World War II.
The returns above[6] reflect the trailing five-year annualized return of a hypothetical portfolio (the value vs. growth portfolio) that goes up when value stocks are outperforming growth stocks and down when growth is outperforming value. In this case, we look at the relative performance of the 20% least expensive (VALUE) companies in relation to the 20% most expensive (GROWTH) companies. All returns are compounded monthly.
The chart shows that value outperforms growth across most five-year periods. In fact, it does so by roughly 5% annualized over time. However, since World War II, there have been six distinct periods when growth outperformed value on a trailing five-year compounded return basis. We are currently in one of these periods, with the previous period occurring during the dot-com era.
Therefore, it is of great interest to examine how value has previously performed following similar times in the past. This chart provides a perspective.
During the previous five periods when growth outperformed value, value subsequently delivered very strong results over the next 5+ years. In the current cycle, the value rebound has not yet occurred.
Cycles – takeaways
In both cases, as we examine value investing in relation to growth stocks and to the S&P 500 index, we hope you take away three things:
- The periodic underperformance of value strategies has not erased their superior results over the long term.
- When value strategies endure a period of underperformance, they have subsequently delivered very strong absolute and relative returns.
- Value investing has done well over time, but hasn’t worked all of the time, and this reflects an important point. Periods of underperformance make value strategies difficult to stick with. If value investing was both fruitful and easy, more would embrace it, and the opportunity to do well with value strategies would be competed away.
It is worth pondering this third statement. It reminds us of a famous Steve Jobs quote on what separates successful and unsuccessful entrepreneurs:
I'm convinced that about half of what separates the successful entrepreneurs from the non-successful ones is pure perseverance.
The same could be said of value investors. The superior long-term returns offered by value strategies would have accrued only to investors with the conviction to persevere across difficult periods. Why would it be any different today?
Mike Seckler and John Alberg are the managers and founders of Euclidean Technologies Management, a Seattle- and New York City-based investment advisor specializing in systematic value investing. Prior to starting Euclidean in 2008, John and Mike co-founded Employease, a software-as-a-service provider that Automatic Data Processing (NASDAQ:ADP) acquired in 2006. Both John and Mike graduated from Williams College in 1994.
[1] https://www.gothamfunds.com/UploadFiles/c1259cc1-d.pdf
[2] In the simulations, Standard & Poor’s COMPUSTAT database was used as a source for all information about companies and securities for the entire simulated time period. The S&P 500 return is the total return of the S&P 500, which refers to the Standard & Poor's 500 Index with dividends reinvested. Simulated returns also include the reinvestment of all income. In each simulation, NYSE, AMEX and NASDAQ companies were ranked according to the stated criteria such as Market Value to Book Value. Non-US-based companies, companies in the financials sector and companies with a market capitalization that, when adjusted by the S& P500 Index Price to January 2010, is less than $400M were excluded from the ranking. The simulation results reflect assets-under-management (AUM) at the start of each month that, when adjusted by the S&P500 Index Price to January 2010, is equal to $100M. Portfolios were constructed by investing equal amounts of capital in the top decile of companies represented by each value factor and then rebalancing monthly to equally weight the evolving constituents of the top decile. The amount of shares of a security bought or sold in a month was limited to no more than 10% of the monthly volume for a security. During the period 1983 to present, the purchase and sale price of a security was based on volume weighted daily closing price of the security during the first ten trading days of each month. Prior to 1983, when daily pricing is not available for all securities, the purchase and sale price of a security was based on the monthly closing price of the security. Transaction costs are factored as $0.02 per share plus an additional slippage factor that increases as a square of the simulation’s volume participation in a security. Specifically, if participating at the maximum 10% of monthly volume, the simulation buys at 1% more than the average market price or, conversely, sells at 1% less than the average market price. Other than these transaction costs, the simulated results do not reflect the deduction of any management fees or expenses. Historical simulated results presented herein are for illustrative purposes only and are not based on actual performance results. Historical simulated results are not indicative of future performance.
[3] Although the S&P 500 Index was formed in 1957, we began this analysis in 1962 because the S&P 500 Total Return data in Compustat is not available prior to that year.
[4] The historical results represented herein are for illustrative purposes only and are not based on actual performance results. The hypothetical portfolio and the associated returns do not reflect the effect of transaction costs, bid/ask spreads, slippage or management fees. Historical results are not indicative of future performance. Kenneth French’s website archives maintain many time series of returns related to fundamental investing. One such monthly time series represents the returns of ten portfolios formed by sorting the universe by each stock’s ratio of book equity to market value and splitting them evenly into deciles. The weight of each stock in each portfolio is proportional to the stock’s market value. In our analysis, we use the portfolio with the highest book equity to market value as the “value approach.” The specific file for these returns can be found here. In this analysis, the S&P 500’s total returns (market appreciation plus dividends) were computed using data from Standard and Poor’s COMPUSTAT database.
[5] We construct the drawdowns of the value approach relative to the S&P 500 as follows. We form a time series by subtracting the monthly S&P 500 total returns from the monthly value approach returns. This time series represents a hypothetical fund that has bought long the value approach and sold short the S&P 500. When the value approach outperforms the S&P 500, this hypothetical fund goes up, and when the opposite happens, it goes down. Therefore, a drawdown of this hypothetical fund represents a period where the value approach is underperforming the S&P 500.
[6] Historical results represented herein are for illustrative purposes only and are not based on actual performance results. The hypothetical portfolio and the associated returns do not reflect the effect of transaction costs, bid/ask spreads, slippage or management fees. Historical results are not indicative of future performance.
All results and the analysis described in the above post exclusively used data obtained from Kenneth R. French’s research data library hosted at http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html. To construct the hypothetical set of returns herein, we used the particular data file at http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/ftp/25_Portfolios_5x5_CSV.zip.This dataset contains the returns of 25 portfolios. The portfolios, which are constructed at the end of each June, represent the intersections of five portfolios formed on size (market equity, ME) and five portfolios formed on the ratio of book equity to market equity (BE/ME).
In our analysis, we constructed a hypothetical portfolio (the value vs. growth portfolio) that goes up when value stocks are outperforming growth stocks and goes down when growth stocks are outperforming value stocks. We calculated the monthly returns for the value vs. growth portfolio to be equal to the average of the five high BE/ME portfolios minus the average of the five low BE/ME portfolios in the dataset referenced above. All returns in our analysis are compounded monthly.
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