As far back as 1934, David Dodd and Ben Graham wrote about value investing in their seminal text, Security Analysis. The two Columbia Business School professors put forth the idea that stocks with low prices relative to their intrinsic value could outperform the market over time. Following their work, countless academics and practitioners confirmed their findings, making value strategies one of the most popular ways to invest. But why has value worked? Among many schools of thought is the idea that value companies are capital-intensive, allowing them to take advantage of their resources during economic recoveries. Think about an automotive manufacturer whose fixed capital gives it the ability to ramp up car production when demand is highest. During periods of economic slowdown, however, being asset-heavy and inflexible become hindrances, causing many value firms to under-perform. This cyclical risk has historically rewarded those who can stick with value over full market cycles.
Value under-performance is cyclical not structural
Given the recent under-performance of the value factor, many investors have expressed concern that the value factor is “broken” due to a structural change in value investing. Investors who share this view point to the price-to-book ratio (P/BV), a common fundamental metric used by traditional value strategies to identify undervalued companies. They highlight P/BV’s inability to account for things like brand value and invested R&D, causing it to underestimate a company’s worth.
While this critique is certainly valid, and one reason we screen for multiple value fundamentals simultaneously in our value factor ETFs, we don’t believe that any single fundamental should be a scapegoat for an entire investment style. After all, value can be found in all sectors and segments of the market, even in those that may not screen well on one individual metric such as P/BV. Rather, we would reiterate that factors, including the value factor, exhibit cyclicality. While factors have tended to outperform over the long-run, in the short-run, they can exhibit periods of under-performance based on the current phase of the economic cycle. The value factor has tended to outperform during recovery periods and may lag during periods of economic slowdown due to the capital-intensive nature of many value-oriented companies. As such, we argue that the recent under-performance of the value factor is not due to a structural change, but instead is due to the current economic environment and the factor’s cyclical nature.
Factors for the long run
In September of 2018, my colleague Andrew Ang explained why he still believes in value factor. He discussed its academic foundations, and noted recent performance to be the fourth-worst drawdown going back to the 1920’s. He also emphasized how periods of under-performance can and will occur, but that there is no reason to think that the long-term premium is gone.
To support these claims, we looked at the value premium (using Fama and French data) since the 1920’s to see just how often cheap U.S. stocks have outperformed expensive ones.
Interestingly, the percentage of positive value premium has historically been only 50% when looking at daily data over the full period. However, as the periods observed increase in length, so too does the percent of time value has outperformed. Over rolling 20-year periods, the value premium has consistently been positive, highlighting the potential benefit of sticking with factor strategies for the long-run.
Don’t forget diversification
While it’s true that value is currently in the throes of a historically significant draw-down, it’s important to realize this shorter-term under-performance is standard factor behavior. The evidence supporting the value factor is still convincing and abundant. All return-enhancing factors — value, size, quality, and momentum — have historically experienced periods of out- and under-performance at different times. Therefore, much as investors diversify across stocks and bonds, they may want to consider having exposures across multiple factors, to balance the prolonged draw-downs of any one individual factor. They also may look to tactically tilt to one or more factors based on the current economic environment.
Holly Framsted, CFA, is the Head of US Factor ETFs within BlackRock’s ETF and Index Investment Group and is a regular contributor to The Blog. Elizabeth Turner, CFA, Vice President and Christopher Carrano, Associate are members of the Factor ETF team and contributed to this post.