Will value investing make a comeback?

Will value investing make a comeback? Inform yourself about two opposing views on the issue, and make up your own mind.

Introduction

I previously wrote about the yawning gap between value and growth stocks, and how this might portent a stock market fall. In end-October, the value-oriented money manager AJO Partner shut its doors for business, because it has been underperforming its benchmark for the past five years. Last week, Barrons ran an article arguing why value stocks might not keep outperforming growth stocks, as they had since 2020 Sep.

So the main question I would like to tackle in this post is: will value investing make a comeback?

I lay out my own thoughts on two opposing views about the issue. The first is by GMO, a money manager which has been in business for more than 40 years. The second is by Aswath Damodaran, a Professor of Finance at the Stern School of Business at New York University.

GMO: this is a time for leaning into Value

Peter Chiappinelli of GMO thinks value investing will make a comeback. In a recent article, he made the following arguments:

• Growth has trounced Value in 8 of the past 11 calendar years;
• During the dot-com era, Growth similarly outperformed Value in 7 of the 11 years to 1999;
• Mean reversion works: after the dot-com bust, Value outperformed Growth by a cumulative 99% from 1999-2006.

Chiappinelli supported his arguments with good data. For example, he had a chart that illustrated the eerie similarity between U.S. Value versus Growth Performance between now and the late 1990s. He also included a very convincing chart that shows that the 113 market-day returns for Growth stocks from 2020 Mar 23rd to 2020 Aug 31st was truly exceptional. It is a 6-sigma event in the history of Growth stock returns dating back to 1985 September. Relative to Value stock returns, it is a 4.5-sigma event.

The US is in a 1999-style bubble

Chiappinelli encapsulated the extent of the US bubble and the animal spirit behind this neatly. In a single chart, he compared Tesla’s market capitalization against that of 12 other global auto-manufacturers. The 12 included US players like Ford and GM, German manufacturers like Mercedes and BMW, Japanese companies like Honda and Nissan, and even Hyundai from South Korea.

Tesla sold 0.4 million vehicles in 2019 against 43.6 million sold by the 12. However, as of 2020 Sep 30th, Tesla’s market cap of US$400 billion easily trounced the combined US$330 billion market cap for the 12.

Not only does he believe value investing will make a comeback, Chiappinelli argues that now is a time for leaning into Value:

We look to a similar period when we trusted in mean reversion when everyone else was doubting it. A period when sticking to a process seemed prudent and disciplined, while others called it stubborn, antiquated, and inflexible. And a period when the worst business decision for GMO ended up being far and away the best and right thing to do for our clients. In other words, a period like 1999.

Peter Chiappinelli, 2020 Nov 4th: TONIGHT, WE LEAVE THE PARTY LIKE IT’S 1999

Ironically, an ex-senior member of the same GMO’s asset allocation team, Edward Chancellor, proclaimed the death of value investing in Institutional Investor in the depth of the GFC.

Damodaran: Value investing has lost its edge

In addition to teaching finance classes, Damodaran also writes a regular blog. He published a three-part series in 2020 Oct 23rd on Value Investing. He even published accompanying videos on YouTube.

True to his academic form, Part 1 includes an extensive backstory to the origins of value investing. He elaborated on the two strands, three variants and four approaches to value investing. My takeaway from this part, however, is the distinction Damodaran made between value and growth:

Put simply, the contrast between value and growth investing is not that one cares about value and the other does not, but in what part of the company the “value error” lies. Value investors believe that their tools and data are better suited to finding mistakes in valuing assets in place, and that belief leads them to focus in on more mature companies, that derive the bulk of their value from existing investments. Growth investors, on the other hand, accept that valuing growth is more difficult and more imprecise, but argue that it is precisely because of these difficulties that growth assets are more likely to be mis-valued.

4 explanations why Value lost its way

In Part 2, Damodaran delved into even more statistics to show that, even during the glory days of value investing:

the evidence that value investing works has always been weaker than just looking at the top lines, though the strength of the evidence varies depending upon the strand of value investing examined.

He then provided more statistics to show how Value has lost its way in the last decade.

Most interesting to me are the 4 different explanations for the under-performance the author collated from practitioners:

1. This is a passing phase!
2. The Fed did it!
3. The Investment World has become flatter!
4. The global economy has changed!

To each explanation, the author included a diagnosis and a prescription. For example, the diagnosis for the “Global economy has changed” explanation is that the shift in economic power to more globalized companies, built on technology and immense user platforms, has made many old time value investing nostrums useless.” And the corresponding prescription is “investors may have to leave their preferred habitat (mature companies with physical assets bases) in the corporate life cycle to find value.”

Damodaran’s prescription

In Part 3, Damodaran revealed his own view. In essence, he believes it’s a combination of Explanation 3 and 4 above.

I believe that value investing has lost its edge, partly because of its dependence on measures and metrics that have become less meaningful over time and partly because the global economy has changed, with ripple effects on markets. To rediscover itself, value investing needs to get over its discomfort with uncertainty and be more willing to define value broadly, to include not just countable and physical assets in place but also investments in intangible and growth assets.

In other words, Damodaran believes that value investing will not make a comeback. At least not in its current form. The world economy has changed and so has the investment world along with it. For value investing to work, practitioners will need to redefine what should be valued, and how to work with uncertainty in the process.

Conclusion

Will value investing come back? Are you more convinced by the mean-reversion arguments GMO presented? Or are you more persuaded by the extensively researched arguments by Damodaran? Or perhaps, you might have the required level of intelligence as described by Fitzgerald, and have “the ability to hold two opposed ideas in the mind at the same time, and still retain the ability to function.”