January 2020

Following a gratifying bounce for value equities in the fourth quarter of 2019, normal service (for this cycle) was resumed in January, with value underperforming and momentum shining. In fact, January was a shocker, with the worst monthly performance of US value versus momentum in 20 years.

This kidney punch coincided with the arrival in my inbox of an academic study by Baruch Lev and Anup Srivastava, ‘Explaining the Recent Failure of Value Investing’. A title like that could not be ignored. The authors claim that value investing – their focus is on the US – has ‘generally been unprofitable for almost 30 years’. The real-world numbers would seem to contradict that claim, but why let facts get in the way of a good story? Anyway, the authors identify two major reasons for value’s supposed failure: 1) accounting deficiencies causing systematic misidentification of value, and particularly of glamour (growth) stocks; and 2) fundamental economic developments, which slowed down significantly the reshuffling of value and glamour stocks (mean reversion), which drove the erstwhile gains from the value strategy.

In the last few decades, the authors argue, an increasing number of companies have grown their businesses by spending more on intangible items such as IT and research & development, relative to tangible assets such as land. These intangibles have been expensed (i.e., taken immediately through the profit & loss account), rather than depreciated over extended periods. Consequently, the value of businesses has been understated as intangibles are not included in the book value, as have profits as intangibles are expensed.

The authors’ adjusted book values to address this and found that ‘in 34 of the 39 years examined … returns from the adjusted value strategy were higher than those of the conventional strategy…and in most years the adjusted returns were substantially higher’. A similar adjustment to earnings produced similar conclusions.

But despite these adjustments, the authors still concluded that ‘recent 10-12 years returns from value investing were unusually low’. This left them searching for a second contributory factor to value’s claimed weak performance. The authors refer to the widely experienced phenomenon of mean reversion as an important historic influence on the performance of the value factor.Mean reversion works, they argue, because outperformance (of any factor) is typically a combination of fundamentals and randomness. Sometimes this randomness moves in the same direction as the fundamentals; at other times it moves in the opposite direction. These ups and downs of randomness drive mean reversion. That was in the old days, anyway. In the new era, the authors show that glamour stocks have remained glamourous for longer and value stocks have remained as value stocks (no sign of Amazon or Royal Mail mean reverting just yet). Why? They pin it on the different economic environment since the global financial crisis, and particularly on the slow growth in bank lending and the ‘prolonged decline in consumer demand’. This leads them to the (not really expanded upon) conclusion that it is ‘not surprising, therefore, that during the past decade the five leading industries of value firms were banking, retail, insurance, wholesale and utilities’. They also show that the operational performance of these companies has been poor since the financial crisis.

In general, I would not disagree with their conclusion, although I would put it another way and say that value firms need either busts or booms to eliminate excess capacity, and since the crisis we have had neither. But all is not quite lost — or more precisely, not all value investors have lost. The authors highlight certain attributes that have helped value companies rise in valuation in this most recent period: those that were relatively small, were making relatively high intangible investment and relatively high capex, have steady sales growth and are buying back shares. And finally, the academics can’t resist turning into forecasters. They highlight that, even after value’s underperformance, on their adjusted numbers the median market-to-book ratios of large glamour and large value firms offer little succour to value investors. In their eyes, this leaves just the hope of operational improvement for value firms. Don’t hold your breath, they say, as the likelihood of the required fundamentals for value companies to succeed or glamour stocks to collapse ‘don’t seem to us likely in the short-median (sic) terms’.

Perhaps they are right, but I would argue differently. With clear signals from central bankers around the world that monetary policy has done as much as it can and governments seeming more than willing to take up the slack through fiscal expansion (thus simultaneously showing both their populist and green credentials), the macro backdrop could be changing from one with inflation targeting at its core to one emphasising nominal GDP growth. These conditions could be perfect for value investors.

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