The third of Carbon’s seven investment principles is that ‘small’ and ‘value’ stocks have higher expected returns than the market.
It’s common sense that the cheaper a stock is when you buy it, the greater the potential risk-adjusted return you can expect from it. Indeed, academic research has proved this. Eugene Fama and Kenneth French demonstrated in a paper written in1992 how, over the long term, so-called ‘value’ stocks have delivered significantly higher returns, or a premium, when compared to growth stocks across the major equity markets.
There are many methods of defining what qualifies as a ‘value’ stock, but the measurement used by Fama and French is ‘book to market’. This measures the company’s accounting valuation (‘book’ value) against its market capitalisation (the value of the shares in issue). Companies with high book to market ratios are value stocks, whereas companies with low book to market ratios are growth stocks. If you’ve visited Carbon’s Aberdeen office, you may have noticed a formula on our glass wall which contains the mathematical abbreviation HML. This stands for High Minus Low and explains how the investible universe of value companies is sorted.
To capture the value premium, many evidence-based advisers recommend including what’s called a ‘factor tilt’ towards value stocks in client portfolios. Historically, it has proved to be a good move. Patient investors with low-cost exposure to value stocks have generally managed to achieve market-beating returns.
In recent years, however, questions have been asked about the wisdom of tilting to value. In many countries, including the US, the value premium has been slightly negative since 2010. In 2018 it delivered its worst annual return of the last decade. This analysis by Factor Research, for example, shows how value stocks in the US typically lost 17.7% in 2018, compared to a fall of 6.59% in the S&P 500. The figure for Europe was worse still, at 17.9%.
Some commentators have even suggested that the value premium is dead. One explanation they give is that the publicity surrounding the value premium has generated fund flows which have effectively eliminated it.
So, should investors give up on tilting to value altogether? After all, value funds are more expensive than traditional index funds which track an entire market. They are also prone to greater volatility.
Our view, however, is that value investing still makes sense. If you’re sceptical, here are three things you ought to bear in mind.
We shouldn’t be surprised when risk factors such as value, size or profitability underperform from time to time. It’s part and parcel of investing. If they didn’t sometimes lag the market, they wouldn’t provide a premium at all. The value premium has, in fact, been remarkably persistent over different time periods.
True, value stocks in the US have underperformed the broader market since 2010. But in other developed markets they have fared much better. A globally diversified value investor should not have paid more than a small penalty, if any at all since 2010.
The good news for value investors today is that, because of the relatively poor performance of value stocks over the past decade, the book-to-market spread between value and growth stocks has widened. In fact, it’s currently at about the same level it was in 1992, when Fama and French published their research. The potential for excess returns is therefore greater now than it has been for some time.
But before you rush into buying value stocks in the hope of catching an upturn in their fortunes, please bear in mind that trying to time factor premiums is impossible to do successfully with any degree of consistency.
It’s extremely hard, if not impossible, to predict when a premium is about to show up. Outperformance tends to come in random bursts, often over a period of just a few days.
A 2017 study by AQR Capital Management concluded: “Our research supports the approach of sticking to a diversified portfolio of uncorrelated factors that you believe in for the long-term, instead of seeking to tactically time them.”
As Warren Buffett likes to say, successful investing has far more to do with temperament than intelligence. You can know the academic literature inside out; but if you don’t have the patience and discipline to stick with your chosen strategy through thick and thin, it won’t count for anything.
The value of investments and the income derived from them can fall as well as rise. You may not get back what you invest.
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