A cura di Jack Forehand, Validea Capital Management
This is the first interview in our new Five Questions series. Each month, we will take an in depth look at a specific issue in the market through a conversation with a leading expert in the area. The goal of this series is to move beyond the high-level discussion typically available in the media and to learn from someone who has studied the issue in depth. In our first interview, we talk with Wes Gray of Alpha Architect about Value Investing.
The topic of value investing is at the forefront of many investors minds these days. Over the long-term, it has been very successful, but in recent years, it has struggled to varying degrees depending on how you measure it. As is typically the case when investment strategies struggle, this had led many to question whether things have changed and it doesn’t work anymore.
I can think of no better person to put what is going on with value in the proper historical perspective than Wes Gray. Wes is the founder of Alpha Architect and the author of Quantitative Value, one of the best books out there on systematic value investing. Wes is also a former Marine and studied under Eugene Fama at the University of Chicago.
Jack: Value stocks have underperformed for over a decade now. Since the beginning of 2007, the Russell 1000 Growth index has more than tripled the Russell 1000 Value index, and value has also underperformed growth significantly in the small-cap space.
There seem to be two schools of thought on what is going on and what it means for the future. One thought process is that this underperformance has created a significant opportunity for long-term value investors since other periods like this historically have typically been followed by a strong reversion. The other is that this underperformance has been justified because the businesses of growth companies have just been doing much better. As someone who has studied value investing extensively, I was wondering what your thoughts are on how this period fits into a historical context and what if anything it means for the likely long-term returns of value stocks going forward?
Wes: This result has a lot to do with the construction of the Russell Indexes. For example, you can take the academic small-value portfolio and the small-growth portfolios since 1927 and plot them relative to the S&P 500. This data is from Ken French’s site and is available here. There are numerous periods where these strategies will drag on the overall index. But, if you directly compare the performance of small value and small growth there are very few periods where small value doesn’t beat small growth on a compounded annual return basis over 5-year rolling periods – to include the most recent 5-year period, where small value eeked out a win over small growth using the data from Ken French’s site. So when arguments are framed around “growth beat value over the past X years,” one should always consider the evidence that supports the statement in the first place.
Regardless, “value is dead” articles are fine by me and I actually love them. The more perceived – and actual experienced pain – the better for long-duration capital compounders, in expectation.
Anyway, we can probably all agree that value hasn’t “killed it” the past decade, regardless of how one measures the performance. Should we be worried about the future efficacy of value? Of course we should be. But let’s try and understand why it might work in the first place.
We always try and reiterate to investors that “open secret” factors, like value or momentum, are robust for a reason – their excess returns are associated with predictions from “rational” economic and “behavioral” economic theories.[1] But “robust” doesn’t mean that these strategies grow money on trees. “Robust” means they generate excess returns, on average, and over the LONG HAUL.[2] These excess returns are often compensation for various forms of risk. And risky bets don’t always pay off – otherwise, risky bets wouldn’t have the word “risky” in them.
Our overarching framework for “active” strategies (which includes “value”)[3], is what we call the sustainable active framework. The basic idea is simple: you get paid to do things that are painful.
The source of the pain can be driven by several components: fundamental risk or mispricing that is costly to exploit (e.g., career risks or trading costs).
There is an enormous academic literature that claims that the value premium is driven by fundamental risk exposure and there are others that claim the value premium is driven by mispricing that is difficult to arbitrage. Eugene Fama and Ken French are the fathers of the “risk-based hypothesis” and Lakonishok, Shleifer, and Vishny are the original gangsters on the “mispricing hypothesis.” (good piece here on the subject).
So with that basic background, if we step back and look at the recent performance of value, which has arguably sucked (at least as measured via cheap book-to-market), we can look at 1) why that has happened, and 2) what do we think will happen on a go-forward basis.
As far as “why” value sucked, it can be boiled down to the two return drivers of the value premium – risk and mispricing.[4] With respect to “risk”, a lot of firms in the cheap book-to-market category are old economy types with dying business models at risk of elimination. Part of the relative performance spread is likely due to the fact that the risk associated with these firms has been realized to the downside in many areas of the economy, and prices now reflect this reality – in short, the risk didn’t pay off. The other potential element is on the mispricing side. Historically value firms have had more positive earnings surprises and these surprises get a large return bounce when the market realizes the surprise and there is a revaluation (i.e., mispricing). This mispricing effect hasn’t been as strong the past 10 years and reactions to surprises have been more muted.
Let’s summarize: risk didn’t pay and mispricing didn’t pay —> value didn’t pay.
Now, what about on a go-forward basis? What would one expect from value stocks? Again, I don’t think there are any surprises here. Value stocks, which in our context means a portfolio of the cheapest stocks in the universe on some price to fundamental, are still going be fundamentally riskier (otherwise they wouldn’t be so cheap!) and we still believe human investors, on average, will overreact to the short-run situations of “crappy firms,” which are affected by “sentiment” shifts. In the end, we’re confident that the economic principles of “why value works” have not changed. Investors who buy dirtball cheap stocks will continue to earn an expected excess premium because they are taking on more fundamental risk and probably taking on more career risks – premiums that will probably pay off, on average, over the long-haul.
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