**As seen on Forbes**
Frank Armstrong, III
The value premium has been absent without leave for several years. Over the longer term, value has been a huge driver of investment returns. The total return of a large company value strategy exceeded the broader large company strategy by more than two and one half times. That’s not trivial.
But, recently the results haven’t been so sterling. This in turn has caused portfolios with a value tilt to underperform the market and/or growth portfolios. Clearly this is not a result bringing joy to either investors or advisors pursuing this strategy. Frustration leads to second guessing and regret.
So, what should investors do now? Is a value strategy still prudent, or should we throw in the towel?
The additional return that investors require for holding value companies is the value premium. And, over time that value premium has been quite generous. It’s been a highly profitable strategy compared to either holding the entire market or using a growth strategy. A dollar invested in a large company value index in 1928 would have grown to $10,414 by the end of 2015, but only $4129 in a large company index.
Value investing is simply buying cheap stocks. Famous value investors include pioneer investment theorist Ben Graham, and more recently Warren Buffett.
Cheap may be in the eye of the beholder. You could define cheap several ways such as rankling stocks by price to earnings (PE), dividend yield, dividend discount model, price to sales, or price to book (PB). There are many ways to define it.
Academic Explanation for the Value Premium
The definition that best fits the data when explaining historical returns or expected future returns is Book to Market (essentially turning PB on its head). This was advocated by Gene Fama and Ken French in their groundbreaking research on the dimensions of investment returns.
However you define cheap or value, you will observe that across the group those companies are in some form and degree of financial distress relative to their more prosperous growth stock cousins. It stands to reason that distressed companies will always have a higher cost of capital whether they are borrowing from a bank, or issuing bonds or stocks. In the stock market even shares issued 50 years ago will trade hands reflecting the firm’s current cost of capital.
An investor’s return is the flip side of cost of capital. They are equal. The mechanism that links the investor’s required return looking forward to the company’s cost of capital is the stock price falling until the investor’s required return is realized. So, value stocks got cheap for a reason (some form of financial distress), and current price reflects both the company’s cost of capital and the investor’s expected return.
Value investing has paid off more often than not, and the average additional return far exceeds the average negative premiums. The good news blue lines dominate the graph above. But, those pesky red lines do appear, and sometimes they clump together. So, the premium appears randomly and sometimes cyclically.
No imaginable equity strategy will win all the time. If value beat growth and/or market every year we could simply sell growth portfolios, use the proceeds to buy value portfolios, leverage the deal up and sail away forever. But, you know that’s not going to happen in the real world.
However, the odds greatly favor value investors. And the longer we hold a value portfolio, the better the odds look. Let’s look at rolling returns for 5, and 10 years. As we extend the time periods, those pesky red lines recede.
It’s been a lost decade for value stocks, in part because financials which make up a huge portion of the group have performed badly. Banks won’t stay out of favor forever, and historically those decades of underperformance by value stocks are very rare.
Value investing has been a sweet spot in the market. There is strong academic theory to explain the dominance of cheap stocks over expensive ones. And the odds of winning with a value strategy over any particular time frame have been very high. And the longer you hold a value strategy, the more likely it’s going to be a winner.
It’s worth noting that value premium shows up everywhere. It’s not limited to US large companies. We get very similar data in US small companies, Foreign Developed Markets and Emerging Markets.
Stay the Course
All available evidence indicates that value is not dead. The current period of underperformance is hardly unprecedented. Any investment strategy has periods of underperformance, and these periods are both random and frequently cyclical. Value strategies have strong academic support backed by overwhelming evidence of persistent, pervasive, and liberal premiums in all global markets and multiple time periods. If you are a value investor, patience is probably your best strategy. If you are not currently a value investor, almost certainly you are missing a very good bet.