The Sleeping Giant: Value’s Dormant not Dead

Oct 30, 2020

In contrast to literary tales of sleeping giants who awaken and immediately unleash their power, things are often less predictable in the real world. When it comes to investing, sometimes dormant investment strategies stay inactive far longer than we might like.

Value is a well-studied style factor that has been academically proven to be a driver of excess returns over long periods of time. However, over the course of its long history, value has gone dormant more than once, signaling periods where expensive companies have meaningfully outperformed those that are more attractively priced. We’re in one of these dormant episodes today.

How Dormant?

The most recent value drawdown, which started in the beginning of 2017, is the worst investors have faced in approximately a century. Take the data compiled by Fama and French, two professors who did seminal work on the value factor, constructed by ranking stocks based on book-to-market ratios. Since the start of their dataset in the 1920s, the period from January 2017 to June 2020 makes this period the worst peak to trough drawdown for value on record. Yet, not unlike your favorite sleeping giant tale, many of the worst years associated with value drawdowns (1934, 1980, and the dot-com exuberance of 1999) were subsequently followed by some of the best years for value investing (1936, 1981, and 2000).

Nevertheless, the losses in value are so large — the iShares MSCI USA Value Factor Index ETF (XVLU) has underperformed the iShares Core S&P 500 Index ETF (XUS) by nearly 25% from January 2017 to Aug 31, 20201, that many investors are asking: what’s the best way to invest in value, and even if it still exists? What should investors do?

U.S. Historical drawdowns in Fama-French’s value factor
(HML, for high book-to-market stocks minus low book-to-market stocks, or value minus growth)

U.S. Historical drawdowns in Fama-French’s value factor

Source: BlackRock; Data from July 1926 – June 2020. Start date represents earliest data available for the Value premium (HML). Factor Premiums are for educational purposes only to demonstrate historical context and are not indicative of future results. The performance shown does not represent the performance of an investible product or portfolio and is not reflective of any investment opportunity available on BlackRock’s platform. Past performance does not guarantee future results.

Is value still value?

We like to measure value with different variables. Value is always about buying cheap relative to intrinsic value, and intrinsic value can take several forms: book value, cashflow to operations, and forward-looking earnings. Several commentators, including myself, have noted that many companies now possess intangible capital to a greater extent than the past. This is true, but it does not take away from the validity of audited balance sheet information, tangible cashflow, or estimates of forward-looking company circumstances by the best analysts.

In our research, we can track the performance of value constructed using intangible assets relative to a measure of value constructed using traditional earnings yields, finding both to be meaningful but different ways to track value performance.

While there is a role for more active formulations of value to complement traditional value measures with intangible value, the underperformance of value is so pervasive that almost no measure of fundamentals is immune from the value drawdown. Thus, most of the value performance is cyclical. We've recently moved to contraction, and in recoveries, value stocks tend to outperform as the operating efficiencies of these companies allow them to take advantage of improving economic conditions.

Factors tend to have different sleeping schedules

All factors—value included—experience periods of underperformance and dormancy. In fact, bearing these periods of pain is one reason that factors have been rewarded over long periods of time. We can potentially dampen the effect of short-term underperformance of single-factor drawdowns by diversifying across other factors.

Take for example the classic case of value and momentum. Using the same Fama and French dataset, we calculate a -0.42 correlation2 between value and momentum premiums going back to the 1920s. This negative correlation is intuitive. All else equal, value companies become deeper value if their prices drop, whereas momentum companies become higher momentum as their prices continue to rise.

Another diversifying factor to value is quality. In a basic dividend discount model, quality is all about the numerator – high quality earnings, while value companies tend to have high discount rates, which operate through the denominator. Consistent with this economic intuition, quality and value have tended to be negatively correlated and this makes the quality factor a potentially powerful complement to existing value exposures.

Looking Ahead

The value giant is sleeping, and it’s hard to forecast exactly when he will awake. I believe the larger risk to investors is being underweight value should a widespread economic recovery take place. So, what can one do to help manage value risk while remaining positioned to capture its potential comeback? Adding allocations to other important factors such as momentum and quality can add diversification and help balance the value factor, rather than giving up on the sleeping giant completely.

Andrew Ang, PhD
Andrew Ang, PhD
Head of Factor Investing Strategies