The Value in Value Investing


David Sowerby, CFA, Managing Director, Portfolio Manager

Value investors have not had as much to cheer about in the last several years. While returns have been comfortably positive, the value approach of seeking to buy undervalued and more deeply discounted securities has lagged the growth style approach. The difference between the value and growth investor can be easily summarized as the value investor seeks stocks whose valuations, as measured by metrics such as their price to earnings ratio (P/E), sell at a discount to the overall market. The growth investor will typically seek securities with greater stability in profits and pay a higher P/E, or valuation.

The value and growth investment styles typically rotate through periods when one or the other has superior returns. Encouraging to the value investor, over the very long term, value investing has a stronger track record with lower volatility. The desire to not overpay for transactions, whether for a home, car or in this case, securities, has an intellectual appeal to value investors. That is supported by legendary investors such as Benjamin Graham, acknowledged as the godfather of value investing, and Warren Buffett.

In the last two years, value stocks have lagged growth stocks. Specifically, using typical Russell indexes for value and growth, the Russell 1000 Growth Index has a compound return of 13.2%, while the Russell 1000 Value Index has compounded at 2.1% as of 12/31/2018. The gap was noticeably wider in the last 18 months. There are sensible reasons for value stocks lagging, in this case think about the popularity of the FANG stocks made up of Facebook, Amazon, Netflix and Google (now Alphabet, Inc.). They are classified as growth stocks and have witnessed above average returns while trading at P/E ratios well in excess of the overall market that a value investor would be less likely to pay for a security. While each of the FANG stocks has its own business model success story, the average P/E ratio of the four is currently 66x trailing profits, compared to the S&P 500 selling at a P/E of 18x.

For the value investor there have been similar periods in the last fifty years where their style of investing has lagged due to some event in the market creating a greater headwind to achieving superior returns. The table below shows four prior periods where value stocks have lagged when the market has had a bias of rewarding much higher-P/E stocks. Eventually, valuation mattered and the outcome proved positive for the value-oriented investor. Those periods were the Nifty 50 in the 1970s, the Biotech-lead market in the early 1990s and the Internet-based Dotcom market of the late 1990s. In each episode, investors were willing to pay significantly higher valuations for stocks relative to their profitability. In each case, investors who pay heed to the value strategy and discipline were subsequently rewarded commensurate with their long-term returns of value investing strategies.

Source: Ibbotson, Russell, FactSet Utilizing French-Fama until 12/31/1978, Russell from 1/31/1979.
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