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There has been a lot of ink consumed in recent months in the popular press and online arguing that value investing is dead.

The authors of such claims provide evidence that picking cheap stocks, meaning stocks with low price/earnings (P/E) or price-to-book (P/B), has been ineffective for at least the last five years. They show, for example, that the S&P 500 value ETF underperformed both the S&P 500 (by about 6 per cent) and the S&P 500 growth ETF (by about 8.5 per cent) during that period.

Likewise, a recent study by Merrill Lynch indicates that the cheapest stocks in the U.S. based on P/B averaged 2.3 per cent over the last five years, whereas the most expensive stocks based on P/B enjoyed an 8.5-per-cent return over the same period. Results are similar in Canada.

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What is going on? Is value investing dead or not? It all depends on how one defines value and growth investing.

Investors widely use the terms value stocks and growth stocks, but many do not know what they mean.

Academic researchers sort stocks by P/E, P/B or other valuation metrics, and form a number of portfolios from the sorted stocks. They call the lowest P/E stocks “value stocks” and the highest P/E stocks “growth stocks.”

While academicians do not know which stocks from the value group value investors will eventually buy, they do know that value investors mostly choose stocks from the lowest P/E group and avoid stocks from the highest P/E group. ETFs only roughly adhere to this rule.

But value investing is more than that. Many investors believe that the only thing value investors do is sort stocks by P/E and invest in the lowest P/E stocks, which cannot be furthest from the truth.

Sorting by P/E (or other metrics) is only the first step in the value investing process. Next, value investors value each of the lowest P/E stocks to find their intrinsic value. Finally, they compare the intrinsic value of each stock to the market price. If the stock price is less than the intrinsic value by at least the so-called “margin of safety” (normally around 33 per cent of the intrinsic value), the stock is considered truly undervalued and is worth investing in.

Having said that, however, even buying from the low P/E group of stocks is not true for all value investors. The deep value Ben Graham-style value investors do, but the Buffett-like investors do not necessarily. But let’s leave this discussion for another time and focus on what most of this discussion has revolved around, namely, the Ben Graham-style value investing.

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Returning to the ETF comparisons: Value ETFs do not meet the value requirements for either value investors or academics.

How is this so?

As indicated above, Ben Graham-style value investors start their analysis with a search process to identify possibly undervalued stocks. This involves looking for stocks which are neglected and/or undesirable. Neglected are stocks that are small cap, have low analyst coverage and low liquidity. Undesirable are stocks with low growth opportunities, low P/E ratio and low P/B.

Value investing is all about finding undervalued stocks, and these tend to be stocks that are smaller, with low analyst following, and low P/E and P/B. However, this is not how ETFs are structured, as they need stocks that are larger and with a lot of liquidity. These tend not to be potentially or truly undervalued stocks. And the results bear this out.

Moreover, P/Es and P/Bs are a function of interest rates. As rates currently converge towards zero, the P/Es and P/Bs of all stocks rise significantly above historical levels. In this setting, companies with very low P/Es and P/Bs tend to be bad companies and investing in them by definition leads to underperformance. My research has demonstrated this clearly.

At the same time, P/Es and P/Bs are also a function of the growth rate of earnings going forward. This relationship can be found in a mathematical formula derived from the equity valuation model taught at every university. Companies have low (high) multiples because markets expect low (high) earnings growth. However, the way growth comes into the mathematical formula implies that high multiple firms are expected to sustain high growth forever; vice versa for low multiple firms. The markets tend to be over-optimistic about growth for high multiple firms and over-pessimistic about growth for low multiple firms. Moreover, growth stocks’ optimistic growth rate assumption interacts with current record-low interest rates. Such interaction benefits growth stocks the most, as their future growth opportunities look very high in present value terms. As a result, particularly in the current interest rate environment, investors tend to overvalue (and overpay for) high multiple firms and undervalue low multiple firms. Hence, the growth stocks’ higher returns.

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Therefore, I have a problem with these writings. They perpetuate a misunderstanding of what value investing is. Value investors indeed buy from the low P/E or low P/B stocks, but they do not buy all such stocks as stocks can have a low P/E (or P/B) simply because they are bad stocks.

George Athanassakos is a professor of finance and holds the Ben Graham Chair in Value Investing at the Richard Ivey School of Business, Western University.

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