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This is the first in a series of nine posts (including this post) on value investing that I’ll be publishing during August. Saying that value investing has had a rough time is a massive understatement. For example, the 10-year return for the S&P 500 Value Index is 35.27%, while the return for the S&P 500 Growth Index is 108.12%. That’s a huge difference of 72.85%!
The long dry spell has got a lot of investors questioning whether value investing still works. I believe that value investing still works. That said, the factors that drive the performance of value investing as a strategy are not static. Several of these variables have become headwinds for traditional long-only value investment strategies.
Anecdotally there seems to be a lot of complacency and/or a lack of awareness of these headwinds among a lot of value investors. And if that wasn’t bad enough, the standard operating procedures used by most value investors are liable to make these problems even worse.
The first step to understanding the headwinds faced by value strategies is to understand the distribution of value stock returns.
There’s no shortage of academic research into value as a factor and anecdotal evidence of the long-term success of value investing. The research clearly shows that portfolios of value stocks out-perform the stock market over long periods. You can find a sample of this research on the website of The Heilbrunn Center for Graham & Dodd Investing at Columbia Business School.
Few of the academic articles discuss the performance of individual stocks within each value portfolio in any detail. One paper that did was Professor Joseph Piotroski’s Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers. Piotroski noted that most value stocks make terrible investments:
However, the success of that strategy relies on the strong performance of a few firms, while tolerating the poor performance of many deteriorating companies. In particular, I document that less than 44% of all high BM firms earn positive market-adjusted returns in the two years following portfolio formation.
In other words, the return distribution for value stocks is strongly positively skewed. That is, a few very large winners more than offset the poor performance of most value stocks.
Piotroski’s F-Score was one of the first attempts (and certainly not the last) to improve the performance of value strategies by trying to pick the “best of the worst”. That’s how Professor Bruce Greenwald described it when I attended the Value Investing course at Columbia Business School.
Another attempt to select the “best of the worst” is the paper The Good and the Bad of Value Investing: Applying a Bayesian Approach to Develop Enhancement Models written by Professors Ron Bird and Richard Gerlach. They explain the reason why most value stocks are bad investments this way:
If this mean reversion occurred for all, or even most, value stocks, then value investing would indeed be extremely rewarding. The problem is that the majority of the so-called value stocks do not outperform the market (Piotroski ). The reason being that the multiples used to identify value stocks are by their nature very crude. For example, the market may expect a firm that has been experiencing poor earnings performance for several years to continue to do so for many more years and this will cause the firm to have a low price-to-earnings multiple. Of course, if the earnings do revert upwards in the immediate future the market will revise the firm’s stock price upwards and the low price-to-earnings multiple would have been reflective of a cheap stock. On the other hand, the market might have been right in its expectations and the firm’s profitability may never improve and so it does not prove to be cheap. Indeed, the firm’s fundamentals might even worsen and so investing in this firm on the basis of its price-to-earnings multiple would prove to be a very bad investment decision.
The point here is that the typical methods for identifying value stocks provide little or no insight into which ones will prove to be good investments and which ones will prove to be bad investments. Fortunately for value investors, the typical longer-term outcome from following such a strategy is that a value portfolio outperforms the market even though only a minority of stocks the included in the portfolio under-perform the market. In Figure 1, we present a histogram of the excess returns over a one-year holding period for all US value stocks over our entire data period. The information contained in this figure not only confirms that the majority of value stocks underperform but also highlights that the outperformance of value stocks is largely driven by a relatively small number of value stocks which achieve an extremely good performance as reflected by the fact that the excess return distribution of value is very much skewed to the right.
What’s interesting in about this paper is that the researchers publish the distribution of value stock returns. As you can see, the distribution is “very much skewed to the right” – lots of losers and only a few big winners.
For example, the number of value stocks that have gone bankrupt and lost 100% of their value in a year is several times larger than the number of stocks that have increased by 300, 400 or even 500%. The majority of value stocks earn a return of zero or less over the next 12 months.
Why does the strong positive skew in the return of value stocks matter?
- Miss the few value stocks that are big winners and the value premium disappears
- Avoid the “dogs” and “value traps” and you boost the performance of a value strategy
- Hold a more diverse portfolio and you’ll reduce the risk that you’ll miss out on the big winners
- Hold a more concentrated portfolio and you’d better make sure you have the stock picking skill to pull it off as the base rate is stacked heavily against you
But the most important reason why it matters is this: the standard operating procedures used by most value investors are negatively skewed! Instead of helping investors to capture more of the big winners (right tail) and less of the losers (left tail), they do the exact opposite.
I’ll explore the reasons why in future posts. Meanwhile, here’s a taste of what you can look forward to:
- Value Investing – Don’t get Skewered!
- Losers in the Driver’s Seat
- Margin of Safety – the Clock’s Ticking
- Reinvestment risk – Got any ideas?
- Growth – the Enemy of Value Stocks
- When cheap isn’t cheap
- Hitting the target
- We liked it at $10, so we like it even more at $7
- Value Investing – Some Suggestions