Value investors have to suffer - a lot

Value investors have been suffering more than their fair share over the last decade. Using Kenneth French’s data on US stocks, the 20% cheapest US stocks by price-to-book value have underperformed the 20% most expensive US stocks for more than a decade now. At the end of this month, the underperformance of value stocks vs. growth stocks will have lasted 12 years, equalling the current record of underperformance from January 1951 to January 1963. However, the current spell of underperformance will undoubtedly last much longer than the underperformance in the 1950s. After all, in January 1963, value stocks had caught up with all their underperformance vs. growth stocks of the past, while as of February this year, value stocks were still 38% under water compared to growth stocks.

These numbers indicate why value investors are suffering so much. It is not just the extremely long duration of the underperformance, it is also the magnitude of the underperformance. Value stocks underperformed growth stocks significantly during the tech bubble of the late 1990s. During the 1990s, value stocks underperformed growth stocks by 2.7% per year on average and in the decade between February 1990 and February 2000 the underperformance was 3.1% per annum.

This decade-long underperformance used to be the record-holder and the impact on asset managers with a value focus had been devastating. Many of the most prominent value managers, like GMO, lost significant amounts of assets and high-profile value investors like Gary Brinson lost their jobs. However, the record underperformance of the 1990s has been shattered since 2008. Between the collapse of Lehman Brothers in October 2008 and the end of September 2018, value stocks underperformed growth stocks by 4.1% per year. Last year, star portfolio manager Nick Train even claimed that “value investing was a 20th century phenomenon”.

One of the drivers of this decade long severe underperformance have been low long-term interest rates. In a sense, the central banks of this world rescued the global economy with ultra-low interest rates and inadvertently killed value investing. If long-term interest rates are low, businesses with low credit ratings and a more cyclical business model can refinance their debt at extremely low costs. That means that future growth becomes easy to finance and since interest rates have not risen, weaker, loss-making businesses were not driven out of business because they could continue to pay their interest cost or refinance existing debt at cheaper and cheaper rates. Furthermore, as long-term interest rates remained low for a long time, discount rates for future earnings and dividends declined over time and valuations of stocks increased. This effect is particularly pronounced for companies with earnings that are supposed to grow faster in the future (i.e. growth companies) than for companies with stable cash flows and limited growth (i.e. value companies).

Whether value investing will make a comeback in the 21st century or indeed may have been a 20th century phenomenon as Nick Train explains, will be discussed in our forthcoming “The Long View” publication in early May. Stay tuned for that.

Decade-long relative performance of value vs. growth

Source: K. French, Fidante Capital.