Value investors finally have some good news to cheer. The past week has brought a bounce upward in value stocks – that is, cheap, often unglamorous shares in slow-growth sectors.
For value investors, this turnaround has been a long time coming. One particularly excitable economist at Saxo Bank in Denmark even described it as a “market earthquake.”
Well, maybe. But anyone counting on benefiting from this value quake may want to step back and take a broader view, according to Anup Srivastava, an associate professor at the Haskayne School of Business at the University of Calgary and Canada Research Chair in accounting.
He and Baruch Lev of New York University recently published a paper that seeks to explain the dismal performance of value investing in recent years. Their contention is that flaws in accounting methodology, combined with deeper economic shifts, have undermined the value approach. Their prediction is that it is not going to stage a sustained revival any time soon.
“We look at fundamental trends in our paper – basic trends in what value stocks are and what glamour stocks are,” Prof. Srivastava said in an interview. He argues that unless you believe that Microsoft Corp. and Alphabet Inc. will stop being winners tomorrow, it is difficult to make the case for value investing.
As most investors know, value investing has suffered some tough years since the financial crisis. Since 2009, the performance of the S&P 500 Value Index, a broad benchmark for U.S. value stocks, has lagged both the plain-vanilla S&P 500 Index and even further behind the S&P 500 Growth Index.
What most people do not realize is how long the dismal patch has extended. By Prof. Srivastava’s reckoning, value investing has been a bad bet for most of the past 30 years, barring a brief revival between 2000 and 2006.
One reason for the lacklustre performance is the way that many investors have historically chosen to identify value. They compare a stock’s current price to its book value, and look for situations where stocks are trading for particularly low multiples of book value.
This approach has its challenges. Book value is the difference between a company’s assets and its liabilities, as measured on its balance sheet. But book value is a questionable guide to a company’s actual worth because the balance sheet value of many assets, especially under U.S. accounting rules, is based on what a company historically paid to acquire those assets. The figures are not updated to reflect their current value.
The professors argue the potential for misleading book values has grown in line with the increasing importance of intangible assets – things such as R&D and brand development. Accounting rules typically require companies to treat the money they spend on intangible assets as expenses, rather than as a capital investment. So investments in intangible assets take a cut out of earnings but are not added to book value.
“This expensing of intangibles, leading to their absence from book values, started to have a major effect on financial data” from the late 1980s, according to the academics. It led many value investors to ignore the growing value of tech companies, in particular.
But how about other ways to measure value? Many value investors will tell you that book value is just one of many yardsticks they employ to detect interesting situations.
Prof. Srivastava acknowledges the point. But, he says, any gauge based on book value, earnings or cash flow suffers from the same problem: The accounting convention that dictates that spending on intangible assets gets treated as an expense while not being recognized for the continuing value it creates.
Besides, he asks, if value investors are so much more confident about other yardsticks, why are so many well-known value funds and value investors suffering? Whatever yardsticks they are using to measure value don’t appear to be producing any better results than the book-value criterion.
The poor performance of the value crowd reflects a second factor that the professors explore in their paper.
Value investors depend on what is known as mean reversion – the tendency of many problem-ridden, out-of-favour companies to improve their operations and rebound. This goes along with the corresponding tendency of many glamorous, highly popular companies to lose their lustre and fade back to average.
The problem for value investors is that mean reversion is no longer working as dependably as it once did. Since the financial crisis, cheap stocks have demonstrated a tendency to remain cheap for longer. Between 1989 and 2006, stocks typically fell into the value category and stayed there for 2.5 years before bouncing back to more average valuations. Since 2007, they have been stuck there for 3.3 years.
Similarly, glamour stocks have tended to remain fast-growing and highly valued for longer. They used to linger in the glamour camp for 3.5 years. Now they stay there for 4.5 years.
The slowdown in mean reversion reflects deeper economic shifts. Many value stocks are in sectors such as banking, retail, insurance and utilities. By and large, businesses in those sectors have had a challenging decade. They have not been able to regain their former profitability. In contrast, several glamour companies – think Amazon.com Inc., Alphabet and Facebook Inc. – have gone from strength to strength, with little sign of a reversal in their upward trajectory any time soon.
Value stocks were once prized for their ability to deliver dependable profits even if their growth rates were less than impressive. The past decade has flipped that narrative. Many businesses in value sectors have seen their profits waver, while several fast-growing businesses in glamorous industries have become dependable profit generators. “Maybe Microsoft and Google have become the new utilities,” Prof. Srivastava says. If so, value investors have some rethinking to do.