The analytical framework set out by Benjamin Graham and David Dodd in 1934 was very intricate, whereas the constituents of value indices such as MSCI’s are selected systematically using a few simple metrics.
"The nature of any recovery tends to be commensurate with the severity of the slump that preceded it"
There is certainly a strong correlation between the performance of systematic value factor indices and the performance of active value managers, but most if not all value managers put their own slant on the framework Graham and Dodd set out.
It was Warren Buffett who said in his 1992 investment letter that value and growth are “joined at the hip”, a reference to the fact that successful investing is about more than just buying stocks with low price-to-earnings or low price-to-book multiples.
The value versus growth question is often posed as a binary one. This is misleading. Buffett’s “hip” quote illustrates that growth and value are not two sides of the same coin, but two components of an investment approach. This is also evident in the way MSCI constructs its indices.
One might think constituents of growth and value indices are simply those towards each end of the same axis. This is wrong. MSCI’s value indices are composed of stocks that have low price-to-book, price-to-earnings, and price-to-dividend multiples. Its growth indices on the other hand have nothing to do with high value, but are composed of stocks that exhibit high forward and historical earnings per share growth, historical sales per share growth and internal growth rate.
This is important because it means there is the potential for stocks to be classified as both value and growth at the same time; as we shall see, there are currently two that fall into this category within the world index. Russell Investments’ methodology is slightly different, with its value indices incorporating stocks that are both cheap and low growth, and its growth indices stocks that are both high growth and expensive.
Nevertheless, despite the different methodologies, the results are similar. Both MSCI’s and Russell’s value indices have outperformed their growth counterparts over the longer term and with lower volatility, but both have underperformed in recent years.
Explanations for this outperformance tend to fall into two categories: risk-based and behaviour-based. The risk-based explanation is that value stocks are lowly valued because there is something wrong with the underlying company, meaning they pose a higher risk. The behavioural explanation, on the other hand, is that they are lowly valued because investors have become pessimistic.
I side with the behaviourists. If value stocks are higher risk, why is their volatility lower? I would be first to assert that volatility is an imperfect measure of risk but, if value stocks are higher risk than growth stocks, one would expect their volatility to be higher. The volatility of the Russell 1000 Value Index has been 16.5% since inception in December 1978, compared with 19.9% for its growth index.
The behavioural explanation makes much more sense. Investor herding is a real phenomenon, and it can move a stock well below its intrinsic value. From this point, the more likely direction is up.
As for growth, there are similarly defined explanations. Growth stocks underperform either because they are low risk or because investors put too much faith in a company’s growth prospects. I think you can guess which side I am on.
The reality is that it is a lot harder than many think for a company to make decent returns on investment. The excitement can often turn to disappointment as investment intended to reap rewards goes down the toilet. This all helps to explain why growth has been outperforming value in recent years. With interest rates stuck at low levels and labour markets generally loose, it has been harder for companies to disappoint.
This has meant companies that would struggle in a more competitive environment have found it easier to survive and even thrive, allowing investors to continue to drink the Kool-Aid. Value stocks have not been doing badly but they haven’t done as well as their growth counterparts.
Therefore, the question of whether value will start to outperform really comes down to when the corporate landscape will become more competitive, either because interest rates start going up or labour markets begin to tighten – they normally go hand in hand.
Beyond the US, it is hard to say when interest rates will start going up. The big developed countries are all at different stages of their economic recoveries, with the US now leading the way, the UK next and Europe bringing up the rear. Interestingly, all the major developed countries and regions exhibit the same pattern with regard to the relative performance of value and growth, as can be seen in the chart opposite. Janet Yellen would seemingly rather live with higher inflation than be forever known as the Fed chair who caused an unnecessary recession by raising rates early.
I suspect value factor indices will continue to underperform growth factor indices for a while longer – in the US, the UK, Europe, and Japan. But, I am optimistic global growth will, in the not too distant future, reach escape velocity, driven by a pick-up in emerging economies as well as continued recovery in consumer and business confidence in developed economies.
The length and nature of any recovery tends to be commensurate with the severity of the slump that preceded it. This, however, does not mean a value-oriented investor cannot do well. Value investing should be about finding stocks whose yields are higher than you think they should be.
This means they do not have to have low valuations in absolute terms but relative terms, and thus allow one to consider more ‘growthy’ opportunities. Such a view of value investing allows us to incorporate two other factors that have persistently outperformed over the long term: quality and size. In fact, our key value metric is dividend yield, which, although it is a component of the various value factors, is also for many index providers a factor in its own right.
As with value, there are various explanations as to why higher quality companies – as defined by stronger balance sheets and better profitability – and smaller companies have outperformed. Investors generally fail to appreciate fully the scope for small companies to get bigger, not just in the near term but also the long term.
As for quality, I would guess stronger balance sheets are associated with lower growth. In reality, the opposite is the case. Although value investing is associated with equities, it is based on the principal of buying things cheaply. This is a principal that is not only sound but also can be applied to other areas such as bonds and even asset allocation.
In the case of bonds, we are looking for those with real yields that are higher than we think they should be and avoiding those that are lower. A good example of the latter would be the 30-year index linked Gilt – if you buy it today and hold it to maturity you are guaranteed to lose 20% of your real capital. In the case of asset allocation, we are looking for markets where yields are higher than we think they should be. This has drawn us towards European equities as well as alternative investments such as asset leasing vehicles and renewable energy infrastructure funds.
What were the two stocks that fell into both value and growth camps? AXA and Daimler. It will be interesting to see how they perform over the next few years.
The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.