At Plum Street Advisors, we maintain certain exposures (or “tilts”) in the portfolios we manage. For example, we maintain a tilt towards small cap stocks that is greater than their market capitalization would suggest, because in the long run, small cap tends to have higher return than large cap. We hold more international stock than is typical for a US investor, because we feel that the typical investor’s holding in international doesn’t sufficiently diversify the portfolio. Similarly, we tilt portfolios slightly toward value stocks rather than growth stocks.
This week, the Wall Street Journal sounded the alarm about value investing with an article titled “Value Loses Shine in Torrid Growth Era” (WSJ, 8/7/17). The article raised questions like whether the markets are “witnessing the death of value investing”. The article points out that growth stocks have outperformed since 2008 and places a particular emphasis on the outperformance in 2017.
While it is clear that growth strongly outperformed during the financial crisis itself, since the market bottom on March 9, 2009, the Russell 1000 Growth Index has returned 19.73% annualized through July 31 2017, only slightly beating the 18.68% annualized return of the Russell 1000 Value Index over the same period. Looking at the period from the market bottom paints a much more modest differentiation and is not entirely unexpected – it has been a long period of modest, but steady, economic improvement in which investors have at times sought greater than market growth. Despite this slight edge for growth since the 2008 crash, at Plum Street Advisors we continue to believe there is good reason to maintain a perennial tilt towards value. There are several reasons for this: value has outperformed historically; despite the 2008 experience, value tends to do better during market downturns; and the value premium has grown since the financial crisis.
1. Value has outperformed in the long run
In a 1993 paper, Eugene Fama and Kenneth French outlined the “three-factor model,” a groundbreaking academic study that identified three distinct elements which influenced equity investment returns. Before then, academicians had identified the primary source of equity returns as a product of market risk—which is to say that investment returns are principally a function of the amount of risk the investor takes. In addition, Fama and French pointed to size (small cap) and book to price (value) as factors which, over the long run, outperform the overall market. Even after the outperformance of these factors was pointed out and widely studied, it has continued to exist. Since the start of their data set in 1926, value has outperformed, as shown in the chart below.
Source: Kenneth French website: http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/index.html
This outperformance of value over growth, using book value portfolios as measured by Kenneth French, has held for almost every 20-year period since the start of the 1926 data, with the sole exception among these 70 overlapping observations being the 20-year period from 1988-2008, when value trailed growth by 5%.
2. Value tends to decline less during market drawdowns
2008 looms large in our collective consciousness, and value stocks underperformed growth stocks during that market downturn. It was an exceptionally deep downturn, raising concerns of widespread bankruptcies in value stocks, and it hit financial stocks (which tend to be value stocks) especially hard. It was also the most recent severe downturn, so it’s the one we tend to remember.
The longer record tells a different story, however. Value stocks tend to fall less sharply in market downturns, providing some downside protection from the overall market. In fact, looking back at the 10 largest downturns of the last 60 years, the 2008 financial crisis was the only market crash where growth beat value. The oldest example, from a 1956-1957 bear market, ended with growth and value approximately even, and value outperformed growth in the other eight downturns – most notably by a very large margin in the growth-stock driven dot-com crash of 2000-2002. The ten largest downturns are shown below:
Source: CapitalSpectator.com and Kenneth French website: http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/index.html
3. Value is relatively cheaper than usual
Value stocks are, by definition, cheaper than growth stocks. But the gap has clearly grown this year. The average price-to-book ratio of stocks in the Russell 1000 Growth Index was 6.7 as of this writing (August 7, 2017), while the average price-to-book ratio of stocks in the Russell 1000 Value Index was a more modest 2.0. The difference in price-to-book ratios between the most and least expensive quintiles, which bottomed during the financial market crisis in 2009 at 3.9, is back up to 12.1 – a level last seen in the late stages of the tech bubble (according to The Boston Company Asset Management, April 2017).
At Plum Street Advisors we maintain a perennial tilt to value because of stronger historical performance and generally better performance during downturns. Approximately 18% of our typical equity portfolio is invested in value indexes.
Markets have historically cycled between value periods and growth periods. The longer a given cycle lasts, the more likely we are to see articles proclaiming the “end” of some type of investing philosophy. While it is difficult, if not impossible, to accurately predict the timing of inflection points, we are confident that they will come, as they always have.