Finding hidden treasure: value investing is back in fashion

Focusing on cheap stocks, historically a highly successful investment strategy, has been a disappointment over the past ten years. But the tide is starting to turn, says Matthew Partridge.

MoneyWeek has long been a big fan of value investing, the strategy of buying “bargain” companies trading at relatively low multiples of earnings, cash flow or book value (net assets). This is because historical evidence suggests that in the long run these types of shares tend to beat the wider market. For example, Elroy Dimson, Mike Staunton and Paul Marsh of the London Business School have done research for Credit Suisse showing that equities with low price/book value (p/b) ratios have beaten the market by an average of around 3% a year in the US between 1928 and 2018 and nearly 4% a year in the UK between 1955 and 2018.
However, since the financial crisis in 2008 this relationship has broken down. Value has lagged growth, the other major investment strategy (which concentrates on stocks with rapidly expanding profits) by 3.8% per year in the USA, and by 3% per year in the UK, notes Marsh. “Cumulatively, since the financial crisis, value has underperformed growth by 35% in the USA and by 29% in the UK.”
This isn’t just a British or American phenomenon, since “the same pattern has occurred in most other markets around the world”. Value has done a bit better than growth over the last few months, but only just. Nevertheless, the big picture is that investors who bemoaned “the death of value” in recent years were wrong. It may soon make a comeback, presenting opportunities for investors.
Why value investing has underperformed
The poor performance of value shares in recent years may be a reflection “of structural changes in the wider economy”, says Inigo Fraser Jenkins of Sanford C. Bernstein. In addition to the rise of technology shares, which until recently have soared, “entire industries and sectors have been disrupted”. So investors can no longer depend on the unglamorous companies that make up the majority of value shares to keep delivering. At the same time, traditional ways of valuing a company have struggled to keep up with the shift of investment from physical assets, such as machinery, to intangibles, such as software, patents and brands.
Value stocks have also encountered some short-term headwinds. Interest rates have been at historically low levels over the past decade, says Simon Gergel, chief investment officer, UK equities of Allianz Global Investors, who manages Merchants Trust. This has been much better for growth companies, for two reasons. “Firstly, a lower discount rate means that investors tend to value the promise of future profits more highly than they would normally do.” Low interest rates also make it much easier for unprofitable companies to keep raising money. In some extreme cases, it can enable what Gergel terms “zombie companies” that have no chance of ever making money, but have an attractive story, to keep functioning. Nor has it helped matters that inflation has been low, so there is little prospect of significantly higher rates in future.
Gergel also reckons that the popularity of both passive funds and those that rely on growth and momentum-based strategies (these involve buying shares that have done well recently and selling those that have done badly) has led to a lot of money moving out of funds that follow a value investment strategy over the last decade.
We think that the move to passive investing is generally good news for investors because it leads to downward pressure on fees and because it is possible to buy passive funds that focus on value shares. However, it certainly seems plausible that the ascendancy of passive funds has reinforced the overall drift away from value in the past decade.

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