Investors have demonstrated a stated preference for Value as an investment style but Value’s underperformance since 2007 is beginning to shake this belief. In this short article, we summarise various arguments that have surfaced recently in an attempt to explain the demise in the value premium.
Interest Rate Regime
A powerful argument that explains value’s demise is the low interest environment that has been in place globally since the market crash of 2008. A CFA blog postulates that in the prevailing low interest rate environment, investors should focus on stocks that have high terminal values or high growth rate of earnings whereas in a high interest rate environment such as the one in the 1980s, they should target true dividend yield as a preferred investment thesis. The interest rate argument is particularly relevant for fundamental investors as their stock selection processes tend to incorporate dividend yield or similar measures, because of which they have experienced significant underperformance versus benchmarks.
Technology Led Disruption
It is increasingly being stated that all sectors now contain technology firms because the technology led market disruption is rife in all sectors of the economy, particularly amongst the so-called value sectors. Value investing is based on the premise of mean reversion of the value risk premia, but this CNBC article postulates that technology if technology is disrupting traditional industries en masse, then the moats that they have built as a safeguard against new competition are porous, and hence is a strong case against mean reversion. We can see this clearly in the retail sector where mighty retail giants have fallen one after the other, to new technology led entrants. Another large value sector, financial services, is witnessing similar disruption to established business models, as FinTech firms completely redefine the business models.
Shrinkage of Value Premium
An academic article by the Booth School at the University of Chicago proposes the argument that the value premium has shrunk over the decades whilst investors continue to base investment processes on the underlying belief that its magnitude is unchanged. The authors determine that the growth premium in excess of the market barely exists, so it is the permanent shrinkage of the value premium that has wreaked havoc to the value as an investment style.
Value investing has been underwhelming since 2007 and the 3rd party arguments summarised in this article would point that value will continue to underperform in its pure form. The conclusion is not that investors should completely turn away from value, but simply tilting towards value as a one-way bet will not yield the results that investors reaped in the decades prior to 2007.
The technology led disruption of business models in sectors that are predominantly associated with value stocks has meant that the underlying definition of capturing value exposure has changed. In many cases, it is difficult to arrive at a definition framework that can be applied uniformly to firms within the same sector making it difficult to capture the true value exposure. At the same time, firms within the same sector are demonstrating high level of performance dispersion, which makes the traditional approach to value investing inherently risky.
One potential framework that investors can use to improve the accuracy of value investing is to overlay trend analysis onto their existing investment process as it can help distinguish between value stocks whose value premium is being recognised by the market and those whose value premium will continue to languish. This Kiplinger article supports our premise that not every value stocks is a good stock and investors need to be discerning and use all possible sources of information to find value stocks whose story is also being recognised by the market. This means that in addition to making a distinction between stocks on their attractiveness from a value perspective, it is vital to determine which good value stocks are being recognised by the market as strong plays and which are being ignored by the market. The ones whose price trends are strong will power value strategies that deliver outperformance, whilst the ones whose price trends are weak will be the ones that will damage value portfolios.
AJO Partners, a value oriented fund with more than 35 years of investing history and over $10 billion AUM, is being closed because Ted Aronson, co-founder & co-CEO, is of the opinion that the firm’s “secret sauce” of finding relative value is at odds with the prevailing market forces and he no longer believes he can deliver outperformance to his clients.
Every process, be it a production process or investment process, cannot remain static for decades. The technology revolution has significantly disrupted business processes that has implicitly disrupted the framework of value investing. The value investment processes must adapt to the new paradigm, because either firms will implement the requisite adjustments to their investment processes, or they will cease to exist because investor patience is wearing thin.
Value investing can and should adapt to the altered dynamics of equity markets of recent years, and the signs are that these alterations are of a permanent nature. Investors assume potential risk by maintaining the traditional approach to value investing in the hope that the prevailing winds will revert back to the past, and the traditional approach to harvesting the value premium will once again begin to bear fruit. How many value-oriented funds or firms will have to shut down before value investing adapts to the new paradigm in equity markets.
Our opinion is that value investing requires a fresh approach, one where the traditional approach is married with an objective disciplined process, to add an element of almost cynical reality check to the value thesis for each position in the portfolio. An overlay of trend assessment fits nicely into this framework as value investors can maintain their current investment processes and merely overlay trend capture to the process. This approach presents an opportunity to reshape old value into “new value” that is in synch with the structural changes that the equity markets are experiencing, by intelligently leveraging a new generation of advanced analytics that will improve the efficacy of value investing.
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By Arun Soni, Global Head of Strategy at Trendrating
Source: Nasdaq, Inc.