Is There Still a Value Effect?

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Advisor Perspectives
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Value investing is the lens through which many view financial markets. Yet, a simple value factor has performed poorly for the last 16 years. Is the value effect over, or will it come back in 2024?

From Graham and Dodd’s hugely influential Security Analysis, to Warren Buffett’s storied career, to today’s value investing firms, like GMO, Oaktree, and GAMCO, the value investing ethos permeates financial markets. Indeed, the value effect is at the heart of much of investing practice and folklore.

Value investing typically means buying solid companies at low valuations, as measured by low price-to-earnings or price-to-book ratios, or by high dividend yields, amongst several other value measures. Proponents of value investing believe such stocks will outperform non-value (growth) stocks over time.

Academic theories suggest that this might happen because either (1) value stocks are, in some sense, riskier than growth stocks and thus compensate investors with additional returns for bearing this added risk; or (2) because value stocks have been temporarily mispriced in less than fully efficient markets (see Campbell, Giglio, and Polk 2023 for a recent discussion). If growth stocks have sufficiently high growth rates (of earnings or dividends), then it is possible that growth stocks, despite their higher valuation multiples, might also have higher expected returns than value stocks.

A lower multiple does not mechanically guarantee higher expected returns.

A common way to analyze the value effect – though one that ignores the “solid company” part of the above description – is to classify stocks as cheap or expensive based on some valuation metric, and then to track the performance of portfolios which go long the cheap stocks and short the expensive ones. Following the work of Fama and French (1992, 1993), a commonly used valuation metric is a company’s book-to-market ratio, which measures the accounting or book value of a firm’s equity relative to the firm’s market capitalization (i.e., the market value of its equity). The higher a firm’s book-to-market ratio, the more value-like is the company, and the lower a firm’s book-to-market ratio, the more expensive is the firm’s stock (presumably, at least in part, because the company will grow faster).

A hypothetical portfolio that is long value and short growth stocks is often referred to as the value factor. While the value factor ignores important implementation details, it nevertheless captures an aspect of the overall performance of real-world value investing strategies. The top panel of the next chart shows the performance of the value factor since 1960. And herein lies the rub: Value did well from the 1960s all the way to 2007, the period just before the global financial crisis (GFC). Since then (the vertical, dotted line in the figure show the start of the quant crisis of 2007), the value factor has performed very poorly, with growth stocks strongly outperforming value stocks over the last 16 years.

Value Effect

The top panel shows the performance of a value factor which goes long the top quintile of book-to-market stocks based on that metric at the start of each year and which concurrently goes short the lowest book-to-market stocks. The bottom panel shows the natural logarithm of the value-weighted average book-to-market of firms in each book-to-market quintile at the end of every year since 1960. Sources: Ken French website, QuantStreet.

Read the full article here by Harry Mamaysky, Advisor Perspectives

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