There isn’t much value in value investing these days.
The value-factor strategy of buying stocks with the lowest valuations and selling those with the highest, pioneered by Eugene Fama and Kenneth French and espoused by none other than Warren Buffett, isn’t working. Sticking to that approach has resulted in a cumulative loss of 15 percent over the past decade, according to a Goldman Sachs Group Inc. report.
During roughly the same period, the S&P 500 Index has almost doubled. While followers of the value-factor strategy are enduring their longest sustained stretch of underperformance since the Great Depression, Goldman Sachs said it may be too early to give up on it.
“The fundamental backdrop for value returns has been especially unfriendly in recent years, but these conditions are unlikely to persist (and are already moderating),” a Goldman Sachs team led by equity strategist Ben Snider, wrote late yesterday in note to clients. “Nonetheless, the maturity of the current economic cycle suggests value returns will remain subdued in the near term.”
Most of the recent weakness can be attributed to the unusually slow growth and prolonged length of the current economic cycle, the strategists wrote. Specific characteristics of the equity market prior to the last crisis were also key, they said.
Waning cyclical headwinds are poised to fade, with the near-term outlook for growth stocks looking better, the report said. But so long “as humans continue to make investment decisions,” Snider wrote, value will work out over the long haul. However, the more widespread appreciation for and adoption of passive funds and smart beta strategies implies returns “will be harder to capture in the future.”
Value stocks tends to outperform when an expansion is broad-based and relatively robust generally at the start of an economic cycle, Goldman Sachs argues, and underperform when the economic backdrop is weak and growth scarce. The team said that the so-called new normal of slower growth magnified investors’ appetite for growth stocks like the FANGquartet.
“The emergence of the ‘secular stagnation’ and ‘lower for longer’ theses inspired investors to allocate especially large premia to stocks capable of generating their own growth, causing the outperformance of high-growth stocks at the expense of value,” wrote the strategists.
Accommodative monetary policy also lifted valuations too uniformly, leaving a smaller premium available on inexpensive names. The distribution of price-to-earnings multiples among S&P 500 companies tightened to “historical extremes” in 2013 amid the adoption of unconventional monetary easing by the biggest central banks in advanced economies, Goldman Sachs observes. That set the stage for the value factor to lag, just as was the case prior to the bursting of the housing bubble.
In the wake of the 2016 U.S. election, expectations of a fiscal boost in the form of pro-growth policies rejuvenated the value sector. But it’ll take redoubled efforts on that front to return to such a favorable backdrop for value or, failing that, a recession and subsequent recovery.
“The early 2017 peak in growth data and inflation expectations also marked the end of outperformance for the value factor, which has since faded again,” they wrote. “The most likely catalyst for an extended period of meaningful value outperformance is an acceleration in economic activity, either as a result of fiscal stimulus or productivity gains in the near term or simply at the start of the next economic cycle.”
Longer-term, the biggest factor working in value’s favor is the mirror image of mankind’s more enduring investing flaw: the tendency for biases and emotion to affect the asset allocation process.
“Among the possible explanations for the historical value effect, one major theme is the tendency of humans to overprice growth profiles and other stock attributes,” wrote Snider. “Even with the growth of assets devoted to quantitative and passive strategies, the presence of humans with different investment processes, risk tolerances, return targets, and psychological biases suggests that some degree of the value effect will persist.”
Which brings to mind this pearl of wisdom from billionaire investor and Donald Trump adviser Carl Icahn’s twitter bio: “Some people get rich studying artificial intelligence. Me, I make money studying natural stupidity. “