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Just Resting

Adam M. Grossman

IN THE FAMILY TREE of investors that began with Benjamin Graham sits a quiet, 100-year-old firm called Tweedy, Browne. This week, it published a chart that offered a new angle on a key debate in the world of personal finance: Is value investing dead—or just resting?

Before I get into the details of the Tweedy chart, I’ll back up and first recap the concept of value investing and why there’s a debate about it.

What does it mean to be a value stock? The simplest definition: It’s a stock selling for less than it’s currently worth. Investors who favor value stocks like to say that they’re trying to buy $1 for 90 cents, and preferably less, with the hope that the price eventually rises to $1.

The opposite of a value stock is a growth stock. Unlike value investors, growth investors aren’t as concerned with finding stocks that look like bargains today. Instead, their focus is on strong, fast-growing companies. Their view is that the share price of a growing company will inevitably rise to reflect the company’s continued success.

How exactly is a stock determined to be a value stock? In some ways, value is in the eye of the beholder. To some, Amazon shares at $3,350 represent a bargain. Because its future looks so bright, they think the stock’s actually worth far more. Other investors, meanwhile, might look at Amazon’s price-earnings ratio of 80—double the overall market average—and see a stock that looks wildly overpriced. In short, value is subjective.

But for practical purposes, the companies that build stock market indexes are the formal arbiters of growth and value, and they each have a methodology for categorizing stocks. For example, here’s how Standard & Poor’s makes the distinction between growth and value:

  • A stock goes into the value category if it’s inexpensive according to three ratios: price-to-earnings, price-to-book value and price-to-sales.
  • A stock goes in the growth category if, as you might guess, it has exhibited strong growth in sales or profits, or has posted strong short-term share price gains.

If value stocks are stocks selling at bargain levels, isn’t that a bad sign? Strong companies have popular stocks and popular stocks tend to be expensive. If a stock is inexpensive, you might conclude that the company is financially weak. That may be true in some cases, but not all. Consider the five largest companies in the S&P 500 Value Index: Berkshire Hathaway, JP Morgan, Walt Disney, Johnson & Johnson and Intel. They might not be as strong as the five largest in S&P’s Growth Index—Apple, Microsoft, Amazon, Facebook and Tesla—but I would hardly call them weak.

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The more important point is this: The valuations on value stocks are much lower than those of their growth peers. And lower valuations tend to be correlated with higher future returns. The logic is simple: All things being equal, it’s better to pay less for something than more. This is a value investor’s primary concern.

Benjamin Graham offered the analogy of a cigar butt on the ground, used and soggy. The idea of picking it up seems distasteful, so it’s hard to imagine anyone paying much for it. But there might be one puff left in it. If it’s lying on the ground and costs you nothing, then it does technically represent a value. You’re getting it for less than it’s worth. This analogy is a little hokey, but it helps illustrate why a bargain price isn’t necessarily a bad thing. A company might not be flawless—it might not be Apple or Amazon—but, if the stock is inexpensive relative to its value, then it could be a profitable investment.

How have value stocks performed? Over time, value stocks have performed demonstrably better than growth stocks. Over the past 90 or so years, value stocks have, on average, outperformed growth stocks by 4.5 percentage points per year. On an annual basis, value stocks have beaten growth stocks more than 60% of the time.

What does that mean in dollar terms? Between 1970 and 2019, $1,000 invested in growth stocks would have turned into $72,000. But if you had invested that same $1,000 in value stocks, it would have ballooned to $153,000.

But more recently, this trend has reversed in dramatic fashion. Over the past 10 years, growth stocks have returned 17.2% a year, while value stocks have returned far less—just 10.5% a year. It’s been a spectacularly disappointing time for value investors.

If value stocks have lagged for so long, isn’t that a sign that maybe times have changed—and that what worked in the past doesn’t work anymore? I don’t subscribe to the idea that “value is dead.” If you refer back to the numbers above, you’ll note that value stocks still delivered 10.5% a year, which is right in line with—if not slightly above—the overall market’s long-term return. The only problem is that it pales in comparison to growth stocks, which have been firing on all cylinders. Like a person of average height standing next to an NBA player, it’s an unfair comparison, and I believe it leads to the wrong conclusion.

My view is that recent years—in which we’ve seen multiple companies cross the $1 trillion mark for the first time—have been an anomaly. If you were to run down the list of the top companies in the value category, I think you’d agree they’re not bad companies. They’re just not colossuses like Apple or Amazon. In fact, the top holding in the value basket, Berkshire Hathaway, is the company that Warren Buffett runs. This is a world-class company by any standard.

This brings me back to the Tweedy, Browne chart. It’s titled “The Historical Tug of War Between Growth and Value,” and it illustrates how the market has oscillated between periods of outperformance by growth and value. In recent years, growth has trounced value. But just before that, value outpaced growth for seven years in a row, from 2000 to 2006.

What does this mean for structuring a portfolio? If the market oscillates between growth and value, and growth has been dominant in recent years, does that mean it’s time to load up on value? Here’s my view:

  • The long-term data clearly favor value stocks. Yes, the market oscillates, but—as Tweedy’s chart illustrates—value has notched many more winning years than growth.
  • There’s a logical reason to believe value will outperform from this point forward. Growth stocks are priced for perfection, while value stocks have margin for error. The price-to-earnings ratio of growth stocks today is 39. For value stocks, it’s a more reasonable 22.
  • But things can change. There was a point in the past, I’m sure, when the historical data would have argued in favor of buying the manufacturers of stage coaches and buggy whips.

The bottom line: I wouldn’t give up on value. What I recommend is a tilt toward value stocks—that is, a modest overweight. While the jury is still out, my view is that value is just resting, not dead.

Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. In his series of free e-books, he advocates an evidence-based approach to personal finance. Follow Adam on Twitter @AdamMGrossman and check out his earlier articles.

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Langston Holland
Langston Holland
8 months ago

All things being equal, it’s better to pay less for something than more.

Wait! We’re supposed to buy low and be patient?! 🙂

Here’s another plot of the Value/Growth trend.

David Powell
David Powell
8 months ago

Nice piece, Adam. Love the Tweedy chart.

I’d gladly take 10.5% average return over a long period on any equity part of my diversified portfolio. I looked at the value index funds I added to last March. U.S. small-cap value is up 71%, int’l small-cap value +61%, Int’l large-cap value +48%, and US large-cap value +43% since those purchases vs +63% for SP500. In the short term it’s hard to imagine how even the value elements have much more room to rise unless they too become unmoored from the gravity of earnings and earnings growth rate.

What might you be writing in future on this topic when (if?) 10-year treasuries rise again to anything like 4 or 5 per cent? Will Mr. Market fully sober up then?

greglee
greglee
8 months ago

The success of value stocks in the past was due to an error. The market overestimated the negative effect that poor prospects of a mismanaged or under-financed company would have. Now we’ve corrected for that, and value is not undervalued. But mistakes aren’t cyclical, so from now on, it’s going to be growth all the way.

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