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It's not surprising that everyone thinks the value investing model is broken.

So-called value stocks, selected because they have cheap book values relative to others, have badly underperformed the broader market during this decade-long bull run. Instead, growth-oriented and large cap technology stocks have grabbed all the headlines.

It's enough to forget that over the much longer-term, value stocks have beaten other investing styles and the market as a whole. But there is a belief in the markets these days that the value model is broken.

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Persistently low interest rates and low inflation may be holding value stocks back.

When the U.S. Federal Reserve and other central banks slashed rates in 2008-2009 to save the global financial system, the move lifted stock valuations, creating a smaller premium for cheap stocks. Financials and energy related names, which are heavily represented in most value strategies, have underperformed due to the stubbornness of low rates and low inflation.

Over five years, the iShares S&P 500 Value ETF (IVE) is up 8.01 per cent, and over 10 years it’s up 11.35 per cent, according to Morningstar. In contrast, the SPDR S&P 500 ETF (SPY), representing the broader market, is up 10.5 per cent and 13.1 per cent, respectively. And the iShares S&P 500 Growth ETF (IVW) is up 12.5 per cent and 14.5 per cent.

Small cap value stocks, which research has shown usually outperform large cap stocks over the long term, have done even worse. Vanguard’s Small Cap Value ETF (VBR) is up just 6.8 per cent over five years.

Investors may be discounting small cap stocks in favor of larger companies that have more resources to weather a market downturn.

A pair of accounting professors, one from New York University’s Stern School of Business and the other from the University of Calgary’s Hasakayne School of Business, recently argued that the value strategy has been broken for far longer than most believe. They trace the problem back 30 years, when companies started expensing intangible assets like research and development and information technology – all things divorced from traditional book value measures.

Even long-time value proponent Warren Buffett has transitioned away from a traditional book value model to one that measures a company's "intrinsic" value, which takes into account things that support a stock's price beyond what can be seen with the naked eye.

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Another thing that has kept value stocks down is technological innovation. It has forced wholesale changes in a variety of sectors over the last decade, helping to push up tech shares while making a dent in the older-school companies forced to react to a changing business environment. Amazon's effect on the retail landscape comes to mind.

But some noticed that earlier this month, value stocks seemed to turn a corner. There was some evidence that investors were trading their high-priced tech shares in for beaten down stocks in other sectors.

As Josh Russell from QS Investors recently pointed out on Alpha Architect’s research blog, the value index (Dow Jones Thematic Market Neutral Value Index) shot up 3.4 per cent on Sept. 9, its best day since the index was introduced in December 2001. The next day, on Sept. 10, it shot up another 2.56 per cent, the seventh-best day since the index began. The flip side of the value factor is momentum, and it has cooled off.

The iShares Edge MSCI USA Momentum Factor ETF (MTUM) is up 21 per cent this year but only 1.27 per cent this month. The iShares Edge MSCI USA Value Factor ETF (VLUE), in contrast, is up 16.9 per cent this year but 7.8 per cent over one month, according to Morningstar.

It's difficult to pinpoint the exact reason why the recent turn in value. It could be telegraphing better future economic growth, which would benefit value, or it could indicate investors are realizing the growth trajectory for some of the most expensive stocks in the market is likely to fall short. Or maybe it's just a rotation into an area of the market where there is acceptable values.

The long-term evidence in the stock market supports having an allocation to value stocks. What the data also shows is that cheap stocks go through periods when they underperform. When the reversion takes hold and investors believe in the value in value, I believe we should expect to see some healthier returns than what we’ve seen in the past 10 years.

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Here are six stocks (three U.S. and three Canada) that score highly using a value composite model off of research by James O’Shaughnessy in his book What Works on Wall Street. The value composite uses a combination of Price/Book, Price/Sales, Price/Earnings, Price/Cash Flow, EV/EBITDA and shareholder yield to rank stocks on a percentile basis.

If value’s turn persists it could be good for many of these names value names, but keep in mind value stocks can be risky so tread lightly into individual names like the ones below.

TickerMarket cap (US$)Value composite rank
General Motors Co.GM-N$53.94-billion1st percentile
Hawaiian Holdings Inc.HA-N$1.269-billion2nd percentile
Realogy Holdings Corp.RLGY-N$695-million1st percentile
Celestica Inc.CLS-N$930-million1st percentile
Mercer International Inc. MERC-Q$835-million2nd percentile
Magna International Inc.MGA-N$16.659-billion3rd percentile

John Reese is chief executive officer of Validea.com and Validea Capital, the manager of an actively managed ETF. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock screen service.

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