September 19, 2016
Does value investing still work? It’s a reasonable question, given the tough stretch that value-based asset allocators have faced over the past several years (at least up until this year, which has so far been quite a good one for Team Value).
GMO’s Ben Inker examined the question of value’s viability in depth in an article published earlier this year. While excellent, Inker’s article is fairly long and technical, so we thought we’d try to summarize some key points here.
Inker starts by framing the question:
It’s no secret that the last half decade has been a rough one for value-based asset allocation. With central bankers pushing interest rates down to unimagined lows, ongoing disappointment from the emerging markets that have looked cheaper than the rest of the world, and the continuing outperformance from the U.S. stock market and growth stocks generally, it’s enough to cause even committed long-term value investors to question their faith.
He goes on to note the folks at GMO — a legendary institutional asset manager, and longtime advocate of value investing — have questioned many assumptions over the past few years, including those they’d held without question for decades. But in the end, they keep arriving back at this conclusion (emphasis ours):
[W]e have not wavered in our belief that taking the long-term view in investing is the right path and that in the long runno factor is as important to investment returns as valuations.
Inker notes that this isn’t the first time value investors’ confidence has been tested. During last decade’s housing bubble, and the dot-com bubble before that, value investors were told that they just didn’t get it, that it was “different this time,” and that the old measures of valuation didn’t apply any more. It took a while, but in both cases, value eventually turned out to matter an awful lot.
Those episodes of value’s apparent irrelevance turned out to be temporary, and Inker believes (as do we) that the same is true for this more recent stretch. We’ll summarize his reasoning below.
Why value investing works
The key reason that value investing has worked, and should continue to work, over the long term is that market prices are much more volatile than fundamentals.
Financial assets’ prices simply move far more than the stability of their underlying cash flows suggest they should. This should be pretty clear from looking at markets’ ongoing history of booms and crashes, but Inker provides a particularly good example based on the work of Nobel Prize winning economist Robert Shiller:
Shiller noted that while we cannot know the future with any degree of certainty, we have no such limitation when it comes to the past. He looked at U.S. stock market prices and dividends back to the 19th century and came up with a “clairvoyant” fair value estimate for the market based on the actual dividends that were paid over the next 50 years.
Here’s the updated version of Shiller’s “clairvoyant” fair value for the US stock market (red and green) vs. actual stock prices (blue).
The stock market’s price fluctuations have been absolutely wild compared to its underlying value — according to Inker, prices have been about seventeen times more volatile than fair value. What’s even more amazing is that this disparity continued even after investors had many decades of evidence that fair value tends to rise at a pretty consistent pace.
Inker sums it up:
The basic driver for long-term value working historically has been the excessive volatility of asset prices relative to their underlying fundamental cash flows, and recent history does not show any evidence of that changing.
What predicts returns, and what doesn’t
The essence of the value approach is to say: we don’t know how far price will get from fair value, or how long it will stay there, but we do think there’s a good chance the two will converge again at some point.
An alternate approach — and, in our observation, the one practiced by most active investors — is to try to anticipate the timing of the price swings themselves. But it’s exceedingly rare to pull that off. First, you have to predict the “news”-type events that typically drive such shorter-term moves. Then, you have to correctly identify the impact these events will have on markets. Given the vast, multi-faceted complexity of markets and the economy, it’s unlikely that many people can consistently be right about either the events or their impacts — let alone both.
Inker offers a couple of examples of how difficult this is. First, he shows GDP growth — certainly a very high-profile and important economic figure — plotted alongside the average economist’s GDP growth forecast:
Professional economists, as a group, have done a very poor job in predicting swings in GDP, and have notably failed to predict a single recession. This is not intended as a shot at economists: the point is that it’s difficult to forecast what our very large and complex economy will do over the short term!
But even were it easier to predict the economy’s zigs and zags, it’s not clear how much help that would be to investors. Inker illustrates this with a chart of positive and negative “surprises” in the monthly employment data (that is to say, whether the economy created more or fewer jobs than economists were expecting):
There wasn’t giant difference in future returns, but the really weird thing is that negative employment surprises were generally associated with better forward returns than the positive ones! So even if one were smart enough to consistently guess the jobs number ahead of time, it would have been more hindrance than help.
Simply looking at present valuations, in contrast, would have been a big help. Inker’s next chart also shows returns following “Jobs Day,” but instead of separating them by positive vs. negative employment surprises, it does so by whether the market was cheap or expensive on those particular days.
Unlike employment surprises, valuation turns out to be a powerful predictor of returns, and in the direction we’d expect. And lest the reader think this is unique to Jobs Day, Inker offers the same chart but using all days, instead of just monthly employment reporting days:
In this case, the difference in returns between cheap and expensive markets is a bit less dramatic, but still much bigger than the employment surprise version, and again in the direction we’d expect: cheap markets lead to better returns, and expensive ones to low returns, by a wide margin.
Conclusion
Inker’s article covers a number of other topics, including bond valuations, the effect of the discount rate on stock prices, and the fact that some seemingly important economic factors aren’t as important to market returns as one would expect. We certainly recommend that all interested parties read the paper in full1. Our purpose here was to provide a relatively quick summary making the case that value-based asset allocation still makes a ton of sense.
Will value investing rise again? There is every reason to believe so (and perhaps it’s already on its way). But we’ll give Mr. Inker the last word:
While the performance of value has been lousy over the last few years, there is little or no evidence that this is due to the markets somehow becoming more efficient. The performance of risk assets in the first quarter of the year, with global stocks falling 11% in the first six weeks only to turn around to rise 13% in the next six, has all of the hallmarks of a market obsessed with short-term surprises, not efficiently discounting the pretty stable stream of cash flows that most asset classes actually give. Efficient markets would show little volatility because the underlying fundamentals are stable. Today’s markets, whatever else they may be, are clearly not efficient in that sense. Hyperactive central bankers and jumpy investors unable to decide between reaching for yield or running for safety may be a significant annoyance for long-term value investors, but we should not forget that their actions also create the very opportunities that such investors need to outperform in the long run.