The Death of Value Investing
Credit crisis reveals weakness in the value discipline.
Value investors deny that the market is efficient. In their view, stock prices are subject to irrational waves of optimism and pessimism. That’s mostly true. But just sometimes, the market’s mood isn’t too far off. A value trap appears when a falling share price correctly anticipates a company’s deteriorating fundamentals. Over the past year, some of America’s best investors have been misled into buying financial stocks by apparently cheap prices. The worst may not be over. If the economy goes into a deep recession, investors could face the greatest value trap since the Great Depression.
As a group, value investors have many attractive qualities. They are contrarian and stoical, knowing that successful investing requires long-suffering patience. They also have fewer illusions than most, modestly acknowledging that they can’t forecast the twists and turns of the economy. Instead, value investors adopt a bottom-up approach, valuing each company on its own merits. They like to think of themselves as owners rather than speculators and tend to operate with longer time horizons.
Value investors dismiss the efficient-market hypothesis. Ben Graham, the spiritual father of this investment sect, argued that asset prices were unduly influenced by shifting market psychology. Investors make money by buying when “Mr. Market” is depressed and stock prices are at fire-sale levels. Value investors also reject the notion that market volatility is a proper measure of risk. As Seth Klarman of the Baupost Group writes in a preface to the latest edition of Graham and Dodd’s Security Analysis (a reprint of the classic 1940 edition), “a volatile stock may become deeply undervalued rendering it a very low risk investment.”
Several of Graham’s followers have amassed great fortunes, notably Warren Buffett. Plenty of research shows that cheap stocks — whether measured by low price-to-book or price-earnings ratios or high dividend yields — have outperformed the market over long periods. There’s a good behavioral explanation for this. Investors extrapolate recent performance, ignoring the tendency of earnings to revert to the mean. As a result, they overpay to acquire the stocks of companies that are growing rapidly and, conversely, undervalue firms that have run into a rough patch. “We have striven throughout to guard the student against overemphasis upon the superficial and temporary,” write Graham and Dodd.
The crash of the technology bubble provided value investors with their finest hour. In the late 1990s bull market, they avoided growth companies and instead piled into out-of-favor stocks that met their stringent valuation criteria. This was a painful strategy before the bubble burst, but it paid off handsomely. The current bear market, however, has produced rather different results. Many value investors have lost heavily.
Why has value done so badly of late? Well, for a start, it had enjoyed a tremendous run since 2002. Easy access to credit and the booming global economy inflated the profits of the cyclical companies that typically make up the value universe. The private equity craze provided many value stocks with a buyout premium. The same stocks were also attractive to a new generation of hotshot hedge fund managers. By 2007, value stocks (as measured by price-to-book) had never been more expensive relative to the market. Since the credit crunch hit in the summer of 2007, the cheapest segment of the U.S. stock market has underperformed the most expensive stocks by roughly 30 percentage points.
Furthermore, the credit crisis is revealing a profound weakness in the value discipline. Graham maintained that analysis should be “concerned primarily with values which are supported by facts and not with those which depend largely upon expectations.” The housing bubble, however, changed many facts. But some of the world’s leading investors appear not to have noticed. Several piled into housing stocks when they were selling at about book value. This proved a disastrous move as falling land prices and slowing sales generated massive losses for homebuilders. Then some of the same investors charged into banks, figuring they were cheap. That also turned out to be a poor idea.
The ongoing travails of value investors raise the question of whether the historically high returns from value are merely compensation received by investors for taking on more risk. This view was first expressed in a famous 1992 paper titled “The Cross-Section of Expected Stock Returns” by Eugene Fama and Kenneth French. These two exponents of market efficiency claimed that value stocks came from a universe of smaller companies that were “more sensitive to economic conditions . . . if the market is rational, [then] the ratio of book value of a stock to the market’s assessment of its value should be a direct indicator of the relative prospects of the firm.”
But the market isn’t rational, says Société Générale strategist James Montier, a prominent champion of value investing. In a recent report Montier takes issue with Fama and French. Value has outperformed the market in every economic downturn since 1975, he says. “Much as fans of the efficient market hypothesis would love us all to believe that value tends to underperform because it is riskier, there is virtually no evidence that this is the case. The risk-based explanations of the value premium are as hollow and meaningless as the rest of EMH.”
The trouble with this analysis is that there has been no truly devastating economic downturn during the study period. Value stocks tend to be found among smaller, more cyclical companies. When the 100-year flood arrives, they are likely to be hardest hit. Graham recommended buying stocks that were priced in the market at less than their net current assets (calculated as cash and working capital less all liabilities). In September, Montier published a list of stocks that meet Graham’s deep value criteria. Yet many of the names look like potential value traps, vulnerable to both the continuing credit crisis and an economic downturn. The list includes several homebuilders, an Irish credit insurance company and a British technology firm that has already entered into bankruptcy.
Cheap stocks (as measured by price-to-book) fared much worse than the market between 1929 and 1932. Graham himself did poorly during the Great Depression. In an essay in the new Security Analysis, James Grant, editor of Grant’s Interest Rate Observer, describes how Graham’s investment partnership, Graham-Newman Corp., went into the 1929 crash owning stocks on margin. Writes Grant: “Compounding that tactical error was a deeply rooted conviction that the stocks that they owned were cheap enough to withstand any imaginable blow.” By 1933, Graham-Newman had lost 70 percent of its starting capital.
The credit bust is bringing fundamental changes to the economy at a mind-numbing speed. Investors have been drawn into one value trap after another. As the credit crisis continues and the global economy worsens, things could get a lot worse for Graham’s disciples. In the three quarters of a century since the Great Depression, value investors have earned a generous premium for investing in smaller and more cyclical stocks. Now they are paying the price.
Edward Chancellor is the author of Devil Take the Hindmost and a senior member of GMO’s asset allocation team.