Andrew's Angle

Value investing: The long-term appeal of
the underdog

Sep 13, 2018

The capacity of factor strategies appears large 

The most recent value underperformance is one of the worst drawdowns experienced since the 1920s. But have faith! Value is cyclical, investors have been pursuing value investing strategies for centuries, and it is based on solid economic rationales.

I love the underdog.

Odds stacked against them. The little battler tackling the job with their head down, not seeking attention, and overcoming adversity. It’s the plotline of hundreds of movies and books—including some of my favorites like Star Wars (the original 1977 Episode IV, of course!). In sports, the underdog is that small school winning against the powerhouse. It’s timeless: David vs Goliath and Cinderella vs her evil step-mother and step-sisters.

Value stocks—stocks with low prices relative to their intrinsic value—are the underdogs of the stock market. And just like in those movie and book plots, sometimes those underdogs get beaten up before they can triumph.

Despite playing the role of the perennial underdog, value investing has proven its merit over the long-term. Here’s why:

  1. First documented by Columbia University Professors Benjamin Graham and David Dodd in their 1934 text, Security Analysis, the principles of value investing focus on buying cheap relative to intrinsic value. In essence, value investing benefits from market behavior of the unpopular becoming popular—the epitome of the underdog story.
  2. Academic research has demonstrated the long-term persistence of a value premium, with one of the first serious seminal academic studies being Basu (1977). Later on, Eugene Fama and Kenneth French became famous partly for producing research showing the value premium endures over long timeframes. Nevertheless, value investing can (and has) underperform(ed) over shorter periods.

Value is trailing, badly

FAANG (Facebook, Amazon, Alphabet, Netflix and Google) stocks are in the news, but the value drawdown is more than the great run by FAANG. The breakout of growth firms is quite widespread. Not only consumer finance and technology; growth firms are also outperforming in more staid industries like food products and chemicals.

In particular, simple measures of value such as low price-to-book companies (used extensively by Fama and French, for example) have disproportionately underperformed. Why? One reason may be that book value does not very well measure intangible capital. Businesses are spending less and less on tangible assets (i.e. factories and machinery), while spending more on intangible assets (i.e. customer databases or trademarks). It’s not bricks and mortar, the new gold is data!

Another reason is that many traditional (asset heavy) value companies are cyclical in nature. As the economy has slowed, those traditional value companies have trailed the performance of their more nimble growth-oriented counterparts. In our current cycle, we can see these economic effects at work. We see a flattening yield curve and slowing economic growth. This late-stage environment is one where value has historically struggled. In the current environment, we also see investors’ biases in over-extrapolating future growth as expensive stocks have surprised on the upside with strong earnings, but cheap stocks have not.

The long-term case for value

Despite the current headwinds, the long-term evidence and rationale for value are substantial.

The value drawdown that started at the beginning of 2017 is one of the worst investors have faced. The performance of value stocks relative to growth stocks can be easily be compared using analysis compiled by Fama and French. The two measure excess returns of value stocks over growth stocks using the ratio of book equity to market equity. Using their dataset, beginning in the 1920s, 2017 was the sixth worst calendar year for the value strategy. The current drawdown to June 2018 is the fourth worst on record and the largest drawdown since the dot-com bubble. It is worth noting that 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).

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; http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html
Beta-adjusted HML Value return from July 1926 – June 2018, shown in USD.
Historical Drawdowns 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.

Upon closer inspection, the year-to-date underperformance in value is due to both growth stocks pulling ahead and value losing ground. Regionally, value underperformance has been widespread, but the underperformance has been most acute for value in the U.S. and Europe. While value has underperformed in most sectors during 2018, declines have been sharpest within the information technology, healthcare, consumer discretionary and industrials sectors.

We can assess value’s effectiveness over longer timeframes using the same Fama-French data set. In the chart below, the book-to-market ratio is high for value stocks and low for growth stocks (an inverse price-to-book ratio) and shows on average, value factors have outperformed growth factors by 4.8% annually over the 90 years of data under review. Although the long run premium for value is positive, value stocks—like any investment—may under-perform in any particular year or even over a multi-year period.

Value over the long run

Value over the long run

Source: BlackRock; http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html
Annual excess returns over period July 1926 – June 2018, shown in USD.
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.

Reviewing the Fama and French data another way, the odds of a negative value premium over any one-year period are uncertain. However, the uncertainty around the persistence of a value premium falls sharply over longer timeframes. Recent research goes one step further and suggests not only is the value premium predictably persistent, but that its predictability and the presence of a value premium is evident across asset classes.1

Given its strong economic rationale and the persistence of the value premium over longer periods, our confidence in value investing is strong. Let’s maintain a broader perspective on long-term results! Currently, value stocks do look attractive from a valuation standpoint and appear far more attractive than expensive growth stocks, many of which have seen prices outpace their fundamentals. We believe there is a large and increasing risk that expensive companies are unable to meet the high expectations built into their valuations.

Remember, remember diversification

All factor premiums are cyclical—earning the long-run rewards requires patience. We believe in diversification across factors, asset classes, and geographies. The recent drawdown in value is a reminder portfolios should remain balanced across many sources of return. We want to diversify across other factors and may even consider modest tilts to emphasize factors with the most attractive opportunity set.

The value factor is the underdog – it’s not flashy, typically is surrounded by low expectations, and often begins to mount a comeback just when you least expect it.

Andrew Ang
Head of Factor Investing Strategies
Andrew Ang, PhD, Managing Director, coordinates BlackRock’s efforts in factor investing. He leads BlackRock’s Factor-Based Strategies Group which manages macro ...