Investment Professionals


Value Investors Are Still The Bagholders


Talk is returning about value investing coming back.

This talk comes and goes every 12 months. It is back again now as central banks are threatening to raise interest rates.

Value investing is where investors try and buy a dollar for 90 cents. It involves looking for stocks that are cheap given the amount of profit they make. Many famous investors, including Warren Buffett, Benjamin Graham and Mario Gabelli, built their careers on it. Academics have supported it – if somewhat ambiguously.

The Unprecedented Outperformance Of Growth Over Value


Source: Fama-French research returns

For a long period of time, it worked well. However, it started failing in a big way after the 2008 financial crisis.

Stuck holding the bag, investors who bought value funds want an explanation. While those who took the opposite trade – buying highly prized growth stocks, often in the technology sector – want to know if their good luck will last.

So why has value investing failed? And could things be about to change?

Markets are competitive, new replaces old

There are common sense explanations for the failure of value investing. Markets are competitive. And in any competitive system, losers copy winners, or they keep losing. Winning stock picking strategies are no different to winning chess openings. Once everyone knows them, they no longer give you the same edge. And value investing is now widely known, with books about Warren Buffett and TV documentaries about French and Fama.

Nowadays everyone buys the dip. Everyone looks at price-to-book (PB) and price-to-earnings (PE) ratios. Everyone has Bloomberg, with valuation metrics at the tips of their fingers. This has meant, as Rochester professor William Schwert notes: “After they are documented and analysed in the academic literature, anomalies often seem to disappear, reverse, or attenuate.”

And something of an admission of this is contained in the disclaimers of value funds: “Past performance is not a predictor of future performance”.

Value investing becomes a moving target

The behaviour of value investing advocates themselves also attests to something gone amiss. Almost all of them these days acknowledge that buying stocks with low PB ratios – value investing as originally conceived – doesn’t work. And instead push for a broader definitions of value investing, to include other metrics like quality.

At its most extreme, these advocates push for meaningless definitions of value investing. Arguing it is “defined as an investment strategy of aiming to pick stocks that are trading at a discount to their intrinsic value.” (But every kind of investing involves buying securities at prices below their intrinsic value).

Meanwhile the great man Warren Buffet himself has given up buying companies like IBM and Kraft, which trade on low valuations. These days he buys electric car companies like BYD and technology growth stocks like Apple, Amazon and Snowflake.

The silver lining: rising rates

There is good news for value investing: it does well when interest rates rise.


Source: Fundstrat, Bloomberg, FAMA until 1975.

When rates rise, unprofitable companies get punished. This is because it makes investors care more about the present and less the future—due to the way that discount rates compound. And value funds almost systematically avoid loss-making businesses. Indeed, one of the most notable facts about the stock market this past year is the pain dished out to unprofitable pockets of the market like SPACs, small biotech, space exploration companies. By avoiding money losers, value investors have avoided this pain.

Value funds are also making big bets on the banks. Looking concretely at the portfolios of value ETFs – which make their holdings transparent – you can see a clear overweight to the financial sector and the banks. Banks are one of the biggest winners of rising interest rates.

Value and growth trade ideas

For investors wanting to buy companies on low valuations, one idea might be to buy Europe with a market weighted index approach. In this way, investors could target a specific region for value characteristics, rather than specific companies. According to Goldman Sachs research desk – one of the best in the business – Eurozone equities are among the cheapest in the developed world. And with this, they believe, comes higher expected returns.

One way to access Europe is through ASX listed fund ETFS EURO STOXX 50 ETF (ASX Code: ESTX).