Academic research has found 3 strategies, or factors, that have historically outperformed the S&P 500. The first is that smaller companies (aka small caps) tend to outperform larger companies. The next factor that excels over long periods is value. The third factor, price momentum, will be covered in a future post.
Value Investing – If it’s Good Enough for Warren…
Value investing is one oldest methods for investing in stocks. Benjamin Graham, known as the father of value investing, wrote one of the first academic textbooks on value investing with his seminal “Security Analysis”, first published in 1934. He followed that up with “The Intelligent Investor”, a classic bestseller which Warren Buffett has called, “By far the best book on investing ever written.”
Research on the value factor has been extensive. As with the size factor, it’s outperformance has been confirmed multiple times, including by Kenneth French and Nobel Prize winner Eugene Fama in their 1993 research paper, “Common Risk Factors in the Returns on Stocks and Bonds.”
What is Value?
This is a term that means different things to people. I would guess that if you asked 10 investors for their definition of value, you would get 5 or 6 different answers. There are a number of different valuation measures and each has their place. A widely used definition, and the one Fama and French use, is called Book to Market value. This is calculated by taking the company’s Book value (Assets – Liabilities) divided by its total Market value (Price per share X Outstanding Shares). In this method, stocks with the highest numbers are considered value stocks while those with the lowest results are considered growth stocks.
How Much Has Value Outperformed?
As the table shows, over time, value stocks have outperformed the overall market (S&P 500) by 2.2% per year (11.6% vs. 9.4%). The margin is even larger versus growth stocks, which historically underperform the market.
Looking at decade returns, you’ll see that value has outperformed in 6 of the past 8. And in a study done by Fidelity Investments, since 1980, over 3 year periods large value stocks outperformed the market 69% of the time.
Why Does it Work?
Unlike small company stocks which require you to take on more volatility for a better return, value stocks fluctuate the same or less than the market overall. So why hasn’t their performance advantage been arbitraged away? The reason is that this strategy will go through extended periods of underperformance. We are currently in one of those periods as value stocks have underperformed the market over the past couple of years.
As with all investment strategies, diversification is key. After all, individual stocks that are undervalued usually are for a good reason (i.e. lower profits, poor management, a dying industry) and can stay that way for years. Some of these stocks eventually rebound and some become better and better values…until they go bankrupt.
Why Aren’t we All Value Investors?
If value stocks outperform growth stocks and the market overall without taking on more risk, why doesn’t everyone invest this way? There are a few different reasons. Perhaps the most important is that one of value’s decades of underperformance was the 1990’s. It was during this time when many investors began having a meaningful amount of money in the market and really began paying attention. Growth stocks were the story of the day, especially in the latter part of the decade, and many investors assumed that they had always outperformed.
Value stocks also typically don’t have interesting stories. People would much rather talk about the technology company that could become the next Apple rather than the industrial company that could be the next Danaher.
Additionally, it’s difficult to stick with a strategy during extended periods of underperformance. No doubt many investors at one time have made the rational decision to follow a value investing strategy, only to find that they don’t have the patience to stick when the strategy hits a period where it lags the broader markets year after year.
Good Things Come to Those Who Wait
Although the value factor is well known and has been for 70 years, its effectiveness has stood the test of time. If you’re an investor who doesn’t mind a more slow and steady approach and has the fortitude to endure periods of market underperformance that can last years, this strategy may be for you.