Is Value Investing Broken, or Is the Market Irrational?

Jack Ablin Market Commentary

Cheap stocks, we’re taught, outperform expensive stocks over time. Although that seemingly makes sense, it hasn’t been the case this year. In fact, value investing hasn’t worked as a strategy for the last five years: it has consistently trailed every other investing style since 2014. Value has trailed momentum-style investing by more than five percentage points annually since then. In fact, over that time frame the Russell 1000 Value Index has fallen 25 percentage points behind the Russell 1000 Growth Index. Since the beginning of 2019 the cheapest stocks in the S&P, whether on a price/earnings or a price/cash flow basis, have underperformed the most expensive selections. The cheapest quintile of the S&P 500 – those stocks sporting the lowest P/E ratios – are trailing the most expensive quintile by 20 percentage points so far this year.

Two powerful trends are buffeting value, the most powerful of which is the tectonic shift to low-cost, passive strategies. Such strategies, which represented 15 per cent of managed assets in 2006, now account for more than one-third of all managed assets, according to Moody’s Investors Service.  Moreover, Moody’s projects that the dollars committed to passive investing will overtake those committed to active management by 2021. As capital shifts, active managers are forced to liquidate their holdings of arguably cheaper, value-oriented stocks. The proceeds pile into the largest stocks in the market, since passive strategies are generally weighted by market capitalization. That’s why the equal-weighted S&P, for example, has trailed the capitalization-weighted S&P by nearly eight percentage points over the last five years.

The other headwind affecting value investing is economic growth; investors tend to focus on equity valuation as economic conditions deteriorate. Growth investments tend to reflect investor optimism about the future. Our current expansion, which just passed its tenth anniversary, is the longest in modern economic history. Value stocks tend to be concentrated in finance and energy while growth stocks are weighted toward technology and communications. Although value companies tend to have more than twice the debt load relative to cash flow than growth companies do, unsurprisingly their valuation multiples are much lower. The Russell 1000 Growth companies, for example, sport a price-to-book ratio of 7.4 vs 2.1 for their Russell 1000 Value counterparts.

It would take a combination of a secular shift in investor buying behavior and a cyclical economic downturn to reverse the trends that are currently weighing on value investing. We suspect our next recession, which is not currently on Cresset’s radar screens, could set off a growth-value reversal. However, value investors often celebrate pyrrhic victories because value tends to outpace growth as markets sell off. The tech bust was a perfect example: between 2000 and 2002, value investing outpaced growth by nearly 30 percentage points . . . the problem was that value stocks slid 25 per cent while growth plunged 55 per cent. In the words of British economist John Maynard Keynes, “The market can stay irrational longer than you can stay solvent.”