Value investing is quite possibly the worst idea…EVER

Value investing is quite possibly the worst idea…EVER

September 14, 2016 Research Insights, Behavioral Finance, Value Investing Research
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(Last Updated On: September 16, 2016)

We believe deeply in the value philosophy as first described by Ben Graham: view stocks as ownership in a firm; buy with a margin of safety; avoid stories; think independently; and so forth.

In fact, I was so intellectually stimulated by value investing I wrote my dissertation on the subject, co-authored an entire book on value investing, and we’ve written numerous blog posts highlighting why value investing is compelling for long-term investors. I still follow my favorite value-focused blogs: OldSchoolValue, ValueWalk, Musing on Markets, BaseHitInvesting, etc.

We are fans.

But I’m not the only fan. The chorus of value cheerleaders, many of whom have been shellacked recently and who have value products to promote, seems to be growing louder.

value-cheerleader

For example, I just returned from the Morningstar ETF conference in Chicago, and most of the speakers talked up the opportunity in value:

Value is cheap relative to growth.

Value is due for a good run.

Low volatility is too expensive, but value spreads are great.

And so on…

RAFI has probably told the most sophisticated story for a value rebound: see here, here, and here. The financial press is also contributing to the story. For instance, here’s a recent article that claims the “growth style [is] now in its ninth year of relative outperformance,” and offers some reasons why value investing may be poised for outperformance. Here’s another piece that suggests, “Value investing is rebounding.”

But is value going to rebound?

One of our intellectual mentors is Charlie Munger, and Charlie advises that in forming our views we should seek to, “Invert, always invert.” As Munger implies, sometimes when we re-frame a concept, we can gain new insights by thinking about it from a different perspective. Let’s give it a whirl…

  • Current frame: Why might value rally?
  • New frame: Why might value NOT rally?

Investing in value is a terrible idea

Mean reversion in a mean-reverting investing strategy sounds great, since we are value investors and we’d love to stop looking like idiots. But perhaps we shouldn’t discount the fact that there is a high probability we actually are idiots and promoting value at these levels is akin to promoting Bacardi 151 at an Alcoholics Anonymous meeting.

So are we buying a falling knife?

falling-knife
Is value currently cheap? Or can it go a lot cheaper?

Value is certainly interesting because the strategy has gotten crushed. Here is a piece where we highlight this fact and here is the associated figure which compares the performance of the generic market (e.g., S&P 500), and Val10 (top decile b/m).

value-yuck
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Bottom line: The market has beaten generic value by over 19 percentage points from 1/2014 to 12/2015!

Just how good or bad is a 19 percentage point drag on the index?

According to the conventional wisdom, if value has performed badly recently, then it is likely to perform better in the near future.

But what does it mean to say value has performed badly? How one measures if “value has worked” can be heavily influenced by the reseacher. For example, are they looking at long/short HML-like portfolios? What valuation metric are they looking at? Equal-weight or market-cap weight construction? And so forth.

As with the 2-year invested growth chart above for value during 2014 and 2015, we’re going to keep this simple: long-only, market-cap weighted, sorted on B/M, using publicly available data so anyone can do the calculations on their own.

To calculate relative performance for value and the broad market we snag data from Ken French’s website:

  • VAL_10 = Top Decile market-weighted value portfolio (Data). Our  long-only “value portfolio.”

Val_10 has eaten a lot of pain the past 2 years. As highlighted earlier, from 1/1/2014 to 12/31/2015 the 2-year total return spread between Val_10 and the generic market is over 19%.

But just how “bad” is this, in a historical context? While 19 percentage points of underperformance over 2 years is a pretty painful run, is it such a rare occurrence that we should be confident that the pain simply can’t continue?

So should we listen to those singing the siren song of factor timing? Go all-in on value?

Here is a chart that looks at rolling 2-year total long-only return spreads between value and the market from 1929 to 2015:

 

2016-09-13-09_43_08-microsoft-excel-product-activation-failed-val10-vs-spx_rolling-10yr-tr-xlsx
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Given this extended backdrop, the recent spread of -19% does not look especially out of the ordinary. 2-year spreads have been this bad, or worse, on many occasions in the past. In fact, with a generic deep value portfolio, one can expect to be trailing by 20 percentage points — or more — around 12% of the time. One can expect to be eating 10 points versus the index over a quarter of the time.

Life sucks as a value investor. In fact, value investing has been digging manager graveyards for over a 100 years.

Here is the histogram of the value-market 2yr total return spreads:

2yr-spread
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

There is a lot of mass in the left tail of the distribution. And today, we’re not even very far out on the left tail!

Value can get a lot worse before it can get better

In short, value investing the past few years has been a bad experience, but things can get a lot worse before they can get better. Sadly, this is the lot of the value investor. Value investing is really a tragic story of pain, anguish, and heartbreak that never really has a happy ending. The expected gains are almost always offset with extreme relative performance pain. For instance, we asked here if investors were prepared for 6 years of tragic underperformance. But why stop there? Cliff Asness traded a live value strategy and lived through a 50%+ drawdown in the late 90’s when the market was cranking out 30% CAGRs. To say that Asness had brass balls would be an understatement–he had diamond crusted platinum balls (or as a reader suggested, diamond crusted tungsten carbide balls)!

Value investing is quite possible the worst decision you will ever make — even at the current relative spreads. The pain will be unbearable and you will be forced to sell. Therefore, value investing is quite possibly the worst idea…EVER.


Editor note: Value investing, for those who have not been scared off already, is only viable for those who have a nuanced grasp and appreciation for the sustainable active investing framework. Read it. Buy and hold. Embrace the suck. If you are brave enough to be a value investor, here is an outline of our approach.


Note: This site provides no information on our value investing ETFs or our momentum investing ETFs. Please refer to this site.


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Please remember that past performance is not an indicator of future results. Please read our full disclaimer. The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Alpha Architect, its affiliates or its employees. This material has been provided to you solely for information and educational purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such. The factual information set forth herein has been obtained or derived from sources believed by the author and Alpha Architect to be reliable but it is not necessarily all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a representation or warranty, express or implied, as to the information’s accuracy or completeness, nor should the attached information serve as the basis of any investment decision. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission from Alpha Architect.


Definitions of common statistics used in our analysis are available here (towards the bottom)




About the Author

Wesley R. Gray, Ph.D.

After serving as a Captain in the United States Marine Corps, Dr. Gray received a PhD, and was a finance professor at Drexel University. Dr. Gray’s interest in entrepreneurship and behavioral finance led him to found Alpha Architect. Dr. Gray has published three books: EMBEDDED: A Marine Corps Adviser Inside the Iraqi Army, QUANTITATIVE VALUE: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors, and DIY FINANCIAL ADVISOR: A Simple Solution to Build and Protect Your Wealth. His numerous published works has been highlighted on CBNC, CNN, NPR, Motley Fool, WSJ Market Watch, CFA Institute, Institutional Investor, and CBS News. Dr. Gray earned an MBA and a PhD in finance from the University of Chicago and graduated magna cum laude with a BS from The Wharton School of the University of Pennsylvania.


  • Marco

    Nice Article Wes, thanks!

  • Dominic Pazzula

    Platinum is too soft. That took diamond encrusted tungsten carbide balls

  • amen to that

  • Tom Rinaldi

    Have you ever considered using risk management rules on value and momentum? It seems like value (or growth/momentum) can lag for such long periods… Why suffer if you are someone who is already bought into the idea that risk management rules work.

  • Trend following the exposures can certainly help. But then you add another layer of tracking error and the potential for ‘relative performance’ pain when you are hedged and the market is on fire.
    Everything works…if you can stick to it.

  • Tom Rinaldi

    Maybe default S&P exposure and momentum or value if the ratio to S&P is over 200-day / positive on a trailing 12-mo basis. I guess I’m struck by the length of the time periods that it can lag and wondering if there’s a defense. I guess it’s like style
    Momentum or something.

  • Adam Kearny

    Just eyeballing the first chart, it looks like the deepest period of underperformance on record (in modern history) was around 2011-12. Yet, I seem to recall most value managers / strategies doing just fine during that period including on a relative basis–it was certainly no 1998-99. This metric seems a little simplistic compared to real world value strategies.
    Wes,
    An interesting chart was circulated recently by Pzena Research–not sure if you’ve seen it. They’ve charted the dispersion between the highest valuation quintile of the market vs. the lowest valuation quintile (not sure which valuation metrics they use). They’re showing we’re at 3.5 sigma above normal. The all-time high was 5.5 sigma at the March 2000 peak. Would be curious as to your thoughts on this. Suggests that we really are at a pretty extreme level in terms of valuation dispersion. I’m not sure how 3.5 sigma and 5.5 sigma compare proportionally though (i.e. skew of the normal distribution).

  • These are just 2 yr total returns so you don’t capture some of the really crazy spreads (like in the late ’90’s when all value managers went bust). You get some crazier moves back in the early part of the century, but in modern times 2011-2012 is pretty high up there.

    re simplistic: Yep, top decile b/m sorts is about as simple as you can get.

    I did see this a while ago. Chalked up to another piece of propaganda trying to pump the “value trade.” Depending on how you cut the cake you can make the data say whatever you want. Value is definitely “cheap” but I think the long view and the point of this post is to say that value can get a LOT cheaper. In fact, I imagine we’ll see a bottom in value when value managers start style drifting into growth (ala 1999). Then we’ll know there is likely a real bottom in the style. Until then it is probably anyone’s guess.

    Here is an old post with decile spreads based on EBIT/TEV (through 2013 before the value blow up): http://blog.alphaarchitect.com/2015/03/04/do-valuation-spreads-matter-for-market-timing/#gs.iHYbFf4
    http://blog.alphaarchitect.com/wp-content/uploads/2015/02/EBIT-yield-spread.png

  • Richard

    Thanks for your interesting article. I didn’t realise recent returns for value investing have been so bad.

    I’ve been sitting out of the market with a sizeable amount of cash since the GFC alarmed at central bank policies and the seemingly intractable problems in Western democracies.

    That’s been an expensive exercise with central banks trying to coerce investors into the market with low interest rates on cash, and all manner of dubious accounting standards adopted, and wide spread share buybacks to prop up prices and sustain executives’ options bonuses.

    Company earnings seem pretty dubious when they are increasingly heavily geared at interest rates that must be unsustainable, it seems to me.

    I was surprised when I saw this article as I thought it would be tongue in cheek but it seems to be serious.

    I read your first two books and have just seen that you now have one incorporating momentum and I will have a look at that because value and momentum seems to me a great approach.

    Perhaps you might tell us that if value investing has done so badly and possibly might continue, do you have a preferred approach now?

    It’s worth remembering that in the book What Works on Wall Street the author identified several strategies that over the long term produced good results but with such savage volatility and drawdowns that he said realistically few people could stomach them. I guess we have to be honest and say most of us have balls of flesh and blood afterall.

  • Peter Wang

    Retail investors like me, our eyes just swirl when encountering the cheerleaders and these inverted arguments. Our feet are frozen in place. That’s why I still just want to invest in broad indices for several different mega asset classes (Antonacci E-GEM and IVY-5), trend-follow for when the world is on fire, then really just forget about it and slept at night.

  • not a bad idea.

  • The article is tongue in cheek in the sense that we are still huge believers in value for the long term. But it is serious in pointing out that the temperament required to handle the amount of potential pain required to be a long term value investor is rare.

    I have no idea why it has done so poorly. All I know is expensive low-quality is beating cheap high-quality