Charts like this are prevalent on social media. The dichotomy is false. We subscribe to Buffett’s view that growth and value are joined at the hip. We are value investors in the sense that we hope to buy low and sell high. Nonetheless, our circle of partners and friends gravitate to the cheap stock style. Accordingly, we’d like to share an interesting paper by AQR (Israel, Ronen and Laursen, Kristoffer and Richardson, Scott Anthony, Is (Systematic) Value Investing Dead? (March 14, 2020). https://ssrn.com/abstract=3554267) on this. Although the evidence examined is pre-Covid, it’s worth examining the paper’s conclusions.
Price to Book’s weak performance
Price to Book anchors most value indices or statistically cheap funds. First up, well-run value funds (and indices such as the one above) should not be using Price to Book as the determinant of cheapness. The authors point out that low price to book does not work well for large cap stocks, and income statement or cash flow based measures are superior.
Share repurchasing has also exploded in the past decade. Strong cash flow businesses end up with book value below zero. Starbucks was cited as an example where book value per share turned negative in Q3 2019. But more generally, share repurchases reduce the book value of equity. This makes successful earnings businesses look optically expensive on a price to book screen.
Intangible assets have also arisen strongly over the past decade. The authors examine evidence whether increasing reliance on knowledge type assets has impacted traditional value metrics. Value has under-performed even when we use other metrics that correct for the rise in intangible assets.
There is also little evidence that the low interest rate environment has led to under-performance of value strategies.
What happened to mean reversion?
The authors critique “systematic” value strategies as being naive in ignoring everything beyond the near term intrinsic value. For value investing to work, valuation multiples have to mean revert. While mean reversion happens on average, they found that mean reversion doesn’t happen when stock prices respond less to fundamental news.
Sadly, the authors present evidence that since the dot.com era, and in the recent past two years, fundamentals appear less relevant for stock prices. There are two opposing effects at play for value strategies. A portfolio of cheap companies tend to be cheap for a reason, with deteriorating fundamentals. Valuation multiples on the other tend to mean revert. What is happening now appears to be a period of deterioration in fundamentals for cheap stocks (but not much greater than normal) and an expansion of prices going away from fundamentals. The latter appears to be much more so than average.
In the post Covid world, investors are likely to see extremely poor investment choices. 100 year Austrian Bond yielding 0.88%, anyone? Risk assets like stocks are a lesser evil in a world of poor choices. We are less concerned about whether Value strategies work or not. The critical check we have is whether a basket of quality global stocks can be constructed at reasonable prices and be a superior option to 0% bonds.