by David Robertson, CFA
February 2019
Despite having a stellar historical record, the value style has underperformed that of growth for most of the past ten years. The long drought, combined with a dramatic reversal in the fourth quarter of 2018, has many investors sensing that the tide is turning for the value style.
Before investors mechanically shift exposure from growth stocks to value stocks, however, it makes sense to search for markers that confirm the opportunity. A lot of things have changed. This isn't to say that the value style won't have its day in the sun again, but investors should consider how things will be different in order to get the most out of the shift.
For certain, there clearly are opportunities for value investing. Rob Arnott, chairman of Research Affiliates, noted in the Financial Times [here], "Right now, US value stocks are trading cheaper than any time other than the 'Nifty Fifty' or the last few months of the financial crisis." He suggests, "I look on this as a wonderful time to ramp up value exposure." Another value manager chimed in, "It's our time."
Opportunities for value can also be assessed in relation to opportunities for growth. The growth style has performed well over the last ten years in large part due to the context of relatively weak economic growth. As such, investors understandably sought out company- and industry-specific opportunities in order to capture what growth could be had.
Because stocks are valued on the basis of discounted cash flows, stocks can still be "cheap" even if they produce good growth, as long as market expectations are too low. It is only when growth forecasts become unrealistically high, as investors reach ever further for growth opportunities, that growth stocks become "expensive". This is exactly what has happened (as I noted in an earlier blog post [here]). The implication is that an important part of the success of the value style is simply avoiding exaggerated claims on growth.
As it turns out, growth is also a key factor in a recent analysis of the value style by Stephen Penman and Francesco Reggiani in the Financial Analysts Journal [here]. While there is a rich body of research explaining why the value style works, Penman and Reggiani add useful nuance to the discussion. Specifically, they show "that the book-to-price ratio (B/P) indicates not only growth but also the risk in buying that growth."
Digging in further, they note, "For a given E/P [earnings-to-price ratio], a high B/P indicates a higher likelihood that growth will not be realized. A high-B/P stock might look cheap, but it could be a trap." In other words, "Buying 'value' may be buying risky earnings growth."
This finding is actually pretty useful because the bane of the value investor is the value trap, i.e., the stock that appears cheap but is cheap for a reason. Penman and Reggiani provide investors with the means by which to disentangle stocks that appear cheap (but have risky growth) from those that actually are cheap.
The Economist recently recognized part of the challenge [here]: "Investors who favour 'value' stocks -- those with a low price relative to book value of a firm's assets -- have had to wrestle more than most with doubt." The article points out, "A value strategy ought (or used) to mean favouring cheap stocks over dear ones." Increasingly, however, the focus on "cheap" stocks has devolved to industry selection.
The article continues, "Value indices seem more and more like a dumping grounds for problem industries." It goes on to list examples of problem industries such as banks, carmakers, and energy firms. Each of these industries, though, has valid threats to growth.
Banks suffer from "a narrow margin between short- and long-term interest rates", carmakers suffer from "trade wars", "emissions scandals", and the competitive threat of "electric vehicles", while energy firms are at risk from "peak oil demand". While such concerns may get overstated, they certainly make growth in those industries riskier.
Another analysis that can be helpful in assessing value opportunities comes from the book, New power: How power works in our hyperconnected world -- and how to make it work for you, by Jeremy Heimans and Henry Timms. The authors introduce the concept of "new power" and contrast it with the model of "old power". In doing so, they also highlight an important dimension that traditional analysis often overlooks.
The authors explain: "Old power models are enabled by what people or organizations own, know, or control that nobody else does." Old power models are familiar and are appropriate in areas where expertise is useful or even necessary. Nobody would want nuclear power plants or bridges or commercial aircraft built by people who didn't understand physics and engineering. When special knowledge and capabilities are combined into a unique capacity to deliver a product or service, it is recognized as a competitive advantage.
New power is different. The authors describe, "New power models demand and allow for more: that we share ideas." They list examples where shared ideas "create new content (as on YouTube) or assets (as on Etsy), even shape a community (think of the sprawling digital movements resisting the Trump presidency)." In other words, new power is about "how to use today’s tools to channel an increasing thirst to participate."
The contrast of power models provides an especially interesting perspective from which to assess value stocks. Since most value stocks tend to be more mature and better-established companies, on the margin, they tend to focus more on defending and extending their competitive advantages than on growing revenues.
There is nothing wrong with this per se. Indeed, it is exactly what should be done when growth opportunities are limited. However, when such conditions are accompanied by ongoing pressure to grow earnings it is all-too-easy for management teams to leverage competitive advantages through practices such as gatekeeping, power brokering and anything else they can muster in order to meet financial goals. In other words, when pressure is applied, it is not hard for "old power" models to overwhelm a company's operational culture and for competitive battles to be fought on those grounds.
At least that's the way competition used to work. Benedict Evans from Andreessen Horowitz highlighted the essence of competition in the technology world in the FT [here]. Evans notes, "moats around tech monopolies are rarely breached. IBM has retained its dominance in mainframe computers, as has Microsoft in PC operating systems." He continued, "But no one worries much any more because innovation has redefined both markets." He concludes, "It's not that someone works out how to cross the moat," but rather, "It's that the castle becomes irrelevant."
Increasingly, innovation is also redefining a lot of industrial and service markets as well. Nobody needs to tell Barnes and Noble what their greatest threat was. It wasn't a bigger network of bricks and mortar bookstores. Amazon made their "castle" irrelevant.
The same type of threat is emerging with a lot of other companies and industries too. I met with a large industrial distribution company about three years ago and not once did the company address Amazon Business as a competitive threat. I also met with a provider of financial data a couple of years ago and a senior executive was completely unaware that passive funds had already taken a 30% share of the market. In these cases, and plenty of others, corporate executives seem so focused on defending against traditional competitors (widening their moats) that they miss the bigger threat from innovation (keeping the castle relevant).
A great example of how innovation can redefine markets was provided by Marco Iansiti and Karim R. Lakhani in a Harvard Business Review article [here]. They noted, "We have seen that digital transformation is no traditional disruption scenario: The paradigm is not displacement and replacement [as it is in typical 'old power' forms of competition] but connectivity and recombination."
The authors go on to describe, "A business model is defined by two things: how the organization creates value for its customers (the customer value proposition) and how it captures that value (how it makes money). Digital transformation changes both." A rich source of opportunities arises from simply asking the questions: "What cumbersome processes in your business or industry are amenable to instrumentation and connectivity? Which ones are most challenging to you or your customers?"
The way in which companies capture and create value also serves as a useful indicator of its paradigm for competition and use of power. Investors, customers and others can decide whether companies are more focused on how to keep making money when growth is slow or on continuously enhancing customer experiences. Some companies do a great job of balancing these demands and others are almost oblivious that there is a tradeoff.
As challenging as it is for business leaders to anticipate threats from innovation and digital transformation, the consequences can be dramatic if they don't. As Heimans and Timms note, "Once old power models lose that [proprietary ownership], they lose their advantage." Without that advantage, they have nothing. In other words, the consequences can not only be nonlinear, but can also be existential.
These two analyses, then, complement one another by identifying important fault lines by which to filter and curate value opportunities. Penman and Reggiani show that stocks may appear to be cheap if their growth is perceived as being risky. Heimans and Timms highlight a distinction between old power and new power which forms a dimension along which risk is often underappreciated by investors and corporate executives alike.
With such tools at our disposal, it is possible to evaluate opportunities for the value style in a more judicious and circumspect way. This can be done by assessing the level of risk associated with various growth opportunities in an effort to avoid value traps.
For example, value stocks have often performed well in healthy economies because strong underlying growth can overcome glitches in company-specific performance; often it just takes some time. Given the low structural growth rate of the US economy (based on low population and productivity growth), however, it will be far less likely for the economy to bail out troubled companies.
In addition, there is increasingly what might be called an "old power" risk. Some companies that are leveraging their competitive advantages into price increases, especially in an effort to offset slow organic unit growth while maintaining high returns, appear to be overplaying their hands. These things don't tend to manifest themselves right away but rather allow ill will to build up with customers until something breaks. When customers get fed up, they accelerate plans to find suitable alternatives.
While it will be important for value investors to identify and handicap risks to growth, it will also be important to identify especially interesting targets. As ever, some of the most interesting value opportunities will exist in stocks that are under-followed or under-appreciated. Stocks that aren't included in major exchange trade funds (ETFs) and aren't followed by major sell-side firms often get overlooked. In addition, there will likely be opportunities in stocks that get included in industry or specialized ETFs that have very different exposures than the fund as whole.
A number of implications arise from this that are important for investors regarding the value style. One is that value investing tends to be more of a defensive strategy. A big part of what works for value is defined by what it is not: A collection of the wildest speculative urges of market participants that are currently embedded in growth stock prices.
Another implication is that the value style may well be more amenable to active management. When interventionist monetary policy is biased to keeping rates low and to inflating the prices of financial assets, companies with strong growth prospects benefit disproportionately because future cash flows are discounted at progressively lower rates. When this happens, every growth stock benefits and the best way for investors to participate is through low cost and broad-based exposure, i.e., passive funds.
Value stocks, on the other hand, tend to outperform on a more idiosyncratic basis. While some industries can be "dumping grounds", each individual company still has its own set of exposures, its own strengths and weaknesses, and its own way of managing through difficulties. Such opportunities are difficult to capture in any kind of systemic way and therefore lend themselves more to active management.
This could end up being useful for investors. In the scenario that "the end of the current cycle could look more like an 'L', instead of a 'V'," as Eric Cinnamond contemplated in a blog post [here], investors won't be able to realize attractive returns from broad market exposure. They will need access to the relatively small subset of stocks that outperform for idiosyncratic reasons.
This would suggest there are at least two big things to prepare for. One is to avoid the losses that will be suffered by stocks with exaggerated growth rates. A second thing is to prepare for coming out the other end of the cycle as Cinnamond is doing. In the event of an "L" shaped recovery, investors will have a much better chance of achieving higher returns through active management.
Finally, the comparison of old power to new power raises an interesting implication for analysts. Heimans and Timms describe, by way of a story about an effort to improve innovation at NASA, that resistance to change is not determined principally by fear of new technology, age, experience, or reputation, but rather by what they call "old power values". The greatest resistance to improving innovation came from people who "believed deeply in the value of expertise. Their own identities grew out of a tradition that venerated individual moments of genius."
It's not too hard to imagine that more mature, better established companies that comprise a large portion of value indexes are also organizations disproportionately riven by "old power values" and by cultures that are less amenable to the paradigms of "connectivity and recombination". Insofar as this is the case, one of the bigger risks investors face may be one that doesn't even show up directly on any risk factor assessment on the 10-K report: The risk that "old power values" prevent an organization from adapting quickly enough to a changing environment.
In conclusion, the good news for value investors is that conditions look ripe for value to outperform again. Louis K.C. Chan and Josef Lakonishok sum up the opportunity for value as well as anyone in a Financial Analysts Journal article [here]: "The value premium, however, can be tied to ingrained patterns of investor behavior or the incentives of professional investment managers. In particular, in the recent market (as in numerous past episodes in financial history), investors extrapolated from the past and became excessively excited about promising new technologies. They overbid the prices of apparent 'growth' stocks while the prices of value stocks dropped far below their value based on fundamentals. Because these behavioral traits will probably continue to exist in the future, patient investing in value stocks is likely to remain a rewarding long-term investment strategy." The fact that the article was published in 2004 highlights the timelessness of their observations.
That said, there is a good chance that history won't so much repeat with the value style as it will "rhyme". While a shift to value may provide a wholesale benefit for some period of time, more enduring outperformance will require changes in the analysis of value situations. Primarily it will be increasingly important to filter out stocks that are cheap for a reason. Value works because stocks get mispriced and the only real way to make such determinations is by doing the hard work of analyzing them individually.
February 2019
Despite having a stellar historical record, the value style has underperformed that of growth for most of the past ten years. The long drought, combined with a dramatic reversal in the fourth quarter of 2018, has many investors sensing that the tide is turning for the value style.
Before investors mechanically shift exposure from growth stocks to value stocks, however, it makes sense to search for markers that confirm the opportunity. A lot of things have changed. This isn't to say that the value style won't have its day in the sun again, but investors should consider how things will be different in order to get the most out of the shift.
For certain, there clearly are opportunities for value investing. Rob Arnott, chairman of Research Affiliates, noted in the Financial Times [here], "Right now, US value stocks are trading cheaper than any time other than the 'Nifty Fifty' or the last few months of the financial crisis." He suggests, "I look on this as a wonderful time to ramp up value exposure." Another value manager chimed in, "It's our time."
Opportunities for value can also be assessed in relation to opportunities for growth. The growth style has performed well over the last ten years in large part due to the context of relatively weak economic growth. As such, investors understandably sought out company- and industry-specific opportunities in order to capture what growth could be had.
Because stocks are valued on the basis of discounted cash flows, stocks can still be "cheap" even if they produce good growth, as long as market expectations are too low. It is only when growth forecasts become unrealistically high, as investors reach ever further for growth opportunities, that growth stocks become "expensive". This is exactly what has happened (as I noted in an earlier blog post [here]). The implication is that an important part of the success of the value style is simply avoiding exaggerated claims on growth.
As it turns out, growth is also a key factor in a recent analysis of the value style by Stephen Penman and Francesco Reggiani in the Financial Analysts Journal [here]. While there is a rich body of research explaining why the value style works, Penman and Reggiani add useful nuance to the discussion. Specifically, they show "that the book-to-price ratio (B/P) indicates not only growth but also the risk in buying that growth."
Digging in further, they note, "For a given E/P [earnings-to-price ratio], a high B/P indicates a higher likelihood that growth will not be realized. A high-B/P stock might look cheap, but it could be a trap." In other words, "Buying 'value' may be buying risky earnings growth."
This finding is actually pretty useful because the bane of the value investor is the value trap, i.e., the stock that appears cheap but is cheap for a reason. Penman and Reggiani provide investors with the means by which to disentangle stocks that appear cheap (but have risky growth) from those that actually are cheap.
The Economist recently recognized part of the challenge [here]: "Investors who favour 'value' stocks -- those with a low price relative to book value of a firm's assets -- have had to wrestle more than most with doubt." The article points out, "A value strategy ought (or used) to mean favouring cheap stocks over dear ones." Increasingly, however, the focus on "cheap" stocks has devolved to industry selection.
The article continues, "Value indices seem more and more like a dumping grounds for problem industries." It goes on to list examples of problem industries such as banks, carmakers, and energy firms. Each of these industries, though, has valid threats to growth.
Banks suffer from "a narrow margin between short- and long-term interest rates", carmakers suffer from "trade wars", "emissions scandals", and the competitive threat of "electric vehicles", while energy firms are at risk from "peak oil demand". While such concerns may get overstated, they certainly make growth in those industries riskier.
Another analysis that can be helpful in assessing value opportunities comes from the book, New power: How power works in our hyperconnected world -- and how to make it work for you, by Jeremy Heimans and Henry Timms. The authors introduce the concept of "new power" and contrast it with the model of "old power". In doing so, they also highlight an important dimension that traditional analysis often overlooks.
The authors explain: "Old power models are enabled by what people or organizations own, know, or control that nobody else does." Old power models are familiar and are appropriate in areas where expertise is useful or even necessary. Nobody would want nuclear power plants or bridges or commercial aircraft built by people who didn't understand physics and engineering. When special knowledge and capabilities are combined into a unique capacity to deliver a product or service, it is recognized as a competitive advantage.
New power is different. The authors describe, "New power models demand and allow for more: that we share ideas." They list examples where shared ideas "create new content (as on YouTube) or assets (as on Etsy), even shape a community (think of the sprawling digital movements resisting the Trump presidency)." In other words, new power is about "how to use today’s tools to channel an increasing thirst to participate."
The contrast of power models provides an especially interesting perspective from which to assess value stocks. Since most value stocks tend to be more mature and better-established companies, on the margin, they tend to focus more on defending and extending their competitive advantages than on growing revenues.
There is nothing wrong with this per se. Indeed, it is exactly what should be done when growth opportunities are limited. However, when such conditions are accompanied by ongoing pressure to grow earnings it is all-too-easy for management teams to leverage competitive advantages through practices such as gatekeeping, power brokering and anything else they can muster in order to meet financial goals. In other words, when pressure is applied, it is not hard for "old power" models to overwhelm a company's operational culture and for competitive battles to be fought on those grounds.
At least that's the way competition used to work. Benedict Evans from Andreessen Horowitz highlighted the essence of competition in the technology world in the FT [here]. Evans notes, "moats around tech monopolies are rarely breached. IBM has retained its dominance in mainframe computers, as has Microsoft in PC operating systems." He continued, "But no one worries much any more because innovation has redefined both markets." He concludes, "It's not that someone works out how to cross the moat," but rather, "It's that the castle becomes irrelevant."
Increasingly, innovation is also redefining a lot of industrial and service markets as well. Nobody needs to tell Barnes and Noble what their greatest threat was. It wasn't a bigger network of bricks and mortar bookstores. Amazon made their "castle" irrelevant.
The same type of threat is emerging with a lot of other companies and industries too. I met with a large industrial distribution company about three years ago and not once did the company address Amazon Business as a competitive threat. I also met with a provider of financial data a couple of years ago and a senior executive was completely unaware that passive funds had already taken a 30% share of the market. In these cases, and plenty of others, corporate executives seem so focused on defending against traditional competitors (widening their moats) that they miss the bigger threat from innovation (keeping the castle relevant).
A great example of how innovation can redefine markets was provided by Marco Iansiti and Karim R. Lakhani in a Harvard Business Review article [here]. They noted, "We have seen that digital transformation is no traditional disruption scenario: The paradigm is not displacement and replacement [as it is in typical 'old power' forms of competition] but connectivity and recombination."
The authors go on to describe, "A business model is defined by two things: how the organization creates value for its customers (the customer value proposition) and how it captures that value (how it makes money). Digital transformation changes both." A rich source of opportunities arises from simply asking the questions: "What cumbersome processes in your business or industry are amenable to instrumentation and connectivity? Which ones are most challenging to you or your customers?"
The way in which companies capture and create value also serves as a useful indicator of its paradigm for competition and use of power. Investors, customers and others can decide whether companies are more focused on how to keep making money when growth is slow or on continuously enhancing customer experiences. Some companies do a great job of balancing these demands and others are almost oblivious that there is a tradeoff.
As challenging as it is for business leaders to anticipate threats from innovation and digital transformation, the consequences can be dramatic if they don't. As Heimans and Timms note, "Once old power models lose that [proprietary ownership], they lose their advantage." Without that advantage, they have nothing. In other words, the consequences can not only be nonlinear, but can also be existential.
These two analyses, then, complement one another by identifying important fault lines by which to filter and curate value opportunities. Penman and Reggiani show that stocks may appear to be cheap if their growth is perceived as being risky. Heimans and Timms highlight a distinction between old power and new power which forms a dimension along which risk is often underappreciated by investors and corporate executives alike.
With such tools at our disposal, it is possible to evaluate opportunities for the value style in a more judicious and circumspect way. This can be done by assessing the level of risk associated with various growth opportunities in an effort to avoid value traps.
For example, value stocks have often performed well in healthy economies because strong underlying growth can overcome glitches in company-specific performance; often it just takes some time. Given the low structural growth rate of the US economy (based on low population and productivity growth), however, it will be far less likely for the economy to bail out troubled companies.
In addition, there is increasingly what might be called an "old power" risk. Some companies that are leveraging their competitive advantages into price increases, especially in an effort to offset slow organic unit growth while maintaining high returns, appear to be overplaying their hands. These things don't tend to manifest themselves right away but rather allow ill will to build up with customers until something breaks. When customers get fed up, they accelerate plans to find suitable alternatives.
While it will be important for value investors to identify and handicap risks to growth, it will also be important to identify especially interesting targets. As ever, some of the most interesting value opportunities will exist in stocks that are under-followed or under-appreciated. Stocks that aren't included in major exchange trade funds (ETFs) and aren't followed by major sell-side firms often get overlooked. In addition, there will likely be opportunities in stocks that get included in industry or specialized ETFs that have very different exposures than the fund as whole.
A number of implications arise from this that are important for investors regarding the value style. One is that value investing tends to be more of a defensive strategy. A big part of what works for value is defined by what it is not: A collection of the wildest speculative urges of market participants that are currently embedded in growth stock prices.
Another implication is that the value style may well be more amenable to active management. When interventionist monetary policy is biased to keeping rates low and to inflating the prices of financial assets, companies with strong growth prospects benefit disproportionately because future cash flows are discounted at progressively lower rates. When this happens, every growth stock benefits and the best way for investors to participate is through low cost and broad-based exposure, i.e., passive funds.
Value stocks, on the other hand, tend to outperform on a more idiosyncratic basis. While some industries can be "dumping grounds", each individual company still has its own set of exposures, its own strengths and weaknesses, and its own way of managing through difficulties. Such opportunities are difficult to capture in any kind of systemic way and therefore lend themselves more to active management.
This could end up being useful for investors. In the scenario that "the end of the current cycle could look more like an 'L', instead of a 'V'," as Eric Cinnamond contemplated in a blog post [here], investors won't be able to realize attractive returns from broad market exposure. They will need access to the relatively small subset of stocks that outperform for idiosyncratic reasons.
This would suggest there are at least two big things to prepare for. One is to avoid the losses that will be suffered by stocks with exaggerated growth rates. A second thing is to prepare for coming out the other end of the cycle as Cinnamond is doing. In the event of an "L" shaped recovery, investors will have a much better chance of achieving higher returns through active management.
Finally, the comparison of old power to new power raises an interesting implication for analysts. Heimans and Timms describe, by way of a story about an effort to improve innovation at NASA, that resistance to change is not determined principally by fear of new technology, age, experience, or reputation, but rather by what they call "old power values". The greatest resistance to improving innovation came from people who "believed deeply in the value of expertise. Their own identities grew out of a tradition that venerated individual moments of genius."
It's not too hard to imagine that more mature, better established companies that comprise a large portion of value indexes are also organizations disproportionately riven by "old power values" and by cultures that are less amenable to the paradigms of "connectivity and recombination". Insofar as this is the case, one of the bigger risks investors face may be one that doesn't even show up directly on any risk factor assessment on the 10-K report: The risk that "old power values" prevent an organization from adapting quickly enough to a changing environment.
In conclusion, the good news for value investors is that conditions look ripe for value to outperform again. Louis K.C. Chan and Josef Lakonishok sum up the opportunity for value as well as anyone in a Financial Analysts Journal article [here]: "The value premium, however, can be tied to ingrained patterns of investor behavior or the incentives of professional investment managers. In particular, in the recent market (as in numerous past episodes in financial history), investors extrapolated from the past and became excessively excited about promising new technologies. They overbid the prices of apparent 'growth' stocks while the prices of value stocks dropped far below their value based on fundamentals. Because these behavioral traits will probably continue to exist in the future, patient investing in value stocks is likely to remain a rewarding long-term investment strategy." The fact that the article was published in 2004 highlights the timelessness of their observations.
That said, there is a good chance that history won't so much repeat with the value style as it will "rhyme". While a shift to value may provide a wholesale benefit for some period of time, more enduring outperformance will require changes in the analysis of value situations. Primarily it will be increasingly important to filter out stocks that are cheap for a reason. Value works because stocks get mispriced and the only real way to make such determinations is by doing the hard work of analyzing them individually.
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