Value Investing: I Get Knocked Down...

Around the Curve

Value Investing: I Get Knocked Down...

Despite more than a decade of underperformance from traditional value factors, it is too soon to declare that this approach is over.

Is the style dead, or just resting? We would argue it’s not quite dead.

First, a review of the facts:

  • Value indices, like the Russell 1000 Value, have trailed growth indices like the Russell 1000 Growth, for seven of the past 11 years, underperforming significantly over that entire time period.
  • Traditional value factors, like low price-to-earnings (P/E) and low price-to-book (P/B), have failed to add value after decades of showing their power.
     

Are Traditional Value Factors Still Relevant?

There are possible and even plausible explanations: value stocks have had slower earnings growth or have not been earning their cost of capital in some areas. Some have even proposed the idea that the traditional “value” factors no longer work.

This last group argues that value has done well, but that the traditional measurements are wrong. Essentially, this group argues that value has worked, but quality, momentum and industry biases have caused managers to miss the power of value. Ultimately, we believe this group—that we’ll refer to as the “value has changed” camp—is extrapolating from a decade where cheapness and/or mean reversion didn’t work and forecasting that will continue. I’m bolding these terms as they are potential behavioral errors!
 

How Have Value Factors Performed?

By one view, it would be an odd point in the economic and market cycle for value factors to start outperforming, given that we are a decade into the expansion. Value factors have historically outperformed at early stages of an economic expansion. It’s been odd that value factors haven’t outperformed when the U.S. or global economy has come out of soft patches during the cycle. We can also layer on how low-volatility stocks have performed, which had the look of a parabolic bubble in late 2018:
 

Source: Bloomberg. Vertical axis: percent premium or discount. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

 

To think that value might not work ever again would almost be suggesting that human nature has changed. If we think about why value investing works, it’s because people get too negative on a company/industry and the price declines to a level that discounts more problems than actually exist. Companies with good balance sheets trading below tangible book value or at single-digit P/E ratios might be a good place to look for these situations, as investors might be incorrectly estimating downside risks. A large number of value sectors have controversy around them—think autos, airlines, energy—and history would suggest the market is overestimating the risks in at least some of these areas.

Some measures are back to tech bubble-like levels; for one, the P/B ratio of the Russell 1000 Growth is at a level unseen since 2000, while the Russell 1000 Value’s P/B ratio is relatively normal.
 

Source: Bloomberg. Index shown: Russell 1000 Growth Index, Price/Book Ratio (vertical axis). This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.


Where Are We in the Cycle?

On another view of the cycle, one could take the view that we’ve had three “mini-recessions” along the way: the 2011 Eurozone crisis, a 2015-16 profit recession, and the 2018-2019 global growth scare or slowdown that currently seems to be showing up in economic data. In this view, 2019 would absolutely be a year where value might do well, as value often does well coming out of recessions and/or slowdowns. Add in that it really wasn’t until 2016 that the bottom 80% of households started seeing meaningful income growth, and this looks more like an environment where we’re in the third year of an expansion, rather than one past a decade in length. Some of this can also be seen in the below-average recovery growth in this longer cycle, which has also been a reason that this cycle had support for being abnormally long.


Is Value Investing Dead?

While we acknowledge the challenges facing value factors, we hardly think the style is dead. To summarize, these are the four main reasons to think that a value cycle might be on its way:

  1. A period of underperformance this long is unprecedented.
  2. Although it would be an odd time in the economic cycle for value to lead, this has not been a typical economic cycle and we may be in a growth scare right now that provides catalysts for value outperformance.
  3. Valuation gaps between value and growth, and value and low volatility stocks, are wide.
  4. Human behavior has not fundamentally changed.

Definitions

The Russell 1000 Growth Index is an unmanaged index of those companies in the large-cap Russell 1000 Index chosen for their growth orientation.

The Russell 1000 Value Index is an unmanaged index of those companies in the large-cap Russell 1000 Index chosen for their value orientation. 

The Russell 1000 Index measures the performance of the 1,000 largest companies in the Russell 3000 Index, which represents approximately 92% of the total market capitalization of the Russell 3000 Index. 

The S&P Low Volatility Index is designed to measure the performance of the 100 least volatile stocks of the S&P 500 Index Volatility is defined as the standard deviation of the security computed using the daily price returns over 252 trading days.

The S&P Value Index is a market capitalization weighted index. All the stocks in the underlying parent index are allocated into value or growth. Stocks that do not have pure value or pure growth characteristics have their market caps distributed between the value & growth indices. 

Top

Important Information

 

All investments involve risk, including possible loss of principal.

The value of investments and the income from them can go down as well as up and investors may not get back the amounts originally invested, and can be affected by changes in interest rates, in exchange rates, general market conditions, political, social and economic developments and other variable factors. Investment involves risks including but not limited to, possible delays in payments and loss of income or capital. Neither Legg Mason nor any of its affiliates guarantees any rate of return or the return of capital invested. 

Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls.

International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.

Past performance is no guarantee of future results.  Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice.  Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not take into account the particular investment objectives, financial situation or needs of individual investors.

The information in this material is confidential and proprietary and may not be used other than by the intended user. Neither Legg Mason or its affiliates or any of their officer or employee of Legg Mason accepts any liability whatsoever for any loss arising from any use of this material or its contents. This material may not be reproduced, distributed or published without prior written permission from Legg Mason. Distribution of this material may be restricted in certain jurisdictions. Any persons coming into possession of this material should seek advice for details of, and observe such restrictions (if any).

This material may have been prepared by an advisor or entity affiliated with an entity mentioned below through common control and ownership by Legg Mason, Inc.  Unless otherwise noted the “$” (dollar sign) represents U.S. Dollars.

This material is approved for distribution in those countries and to those recipients listed below. Note: this material may not be available in all regions listed.

All investors and eligible counterparties in Europe, the UK, Switzerland:

In Europe (excluding UK and Switzerland), this financial promotion is issued by Legg Mason Investments (Ireland) Limited, registered office 6th Floor, Building Three, Number One Ballsbridge, 126 Pembroke Road, Ballsbridge, Dublin 4, D04 EP27. Registered in Ireland, Company No. 271887. Authorised and regulated by the Central Bank of Ireland.

All Qualified Investors in Switzerland:
In Switzerland, this financial promotion is issued by Legg Mason Investments (Switzerland) GmbH, authorised by the Swiss Financial Market Supervisory Authority FINMA.  Investors in Switzerland: The representative in Switzerland is FIRST INDEPENDENT FUND SERVICES LTD., Klausstrasse 33, 8008 Zurich, Switzerland and the paying agent in Switzerland is NPB Neue Privat Bank AG, Limmatquai 1, 8024 Zurich, Switzerland. Copies of the Articles of Association, the Prospectus, the Key Investor Information documents and the annual and semi-annual reports of the Company may be obtained free of charge from the representative in Switzerland.

All investors in the UK:
In the UK this financial promotion is issued by Legg Mason Investments (Europe) Limited, registered office 201 Bishopsgate, London EC2M 3AB. Registered in England and Wales, Company No. 1732037. Authorized and regulated by the Financial Conduct Authority. Client Services +44 (0)207 070 7444

All Investors in Hong Kong and Singapore:

This material is provided by Legg Mason Asset Management Hong Kong Limited in Hong Kong and Legg Mason Asset Management Singapore Pte. Limited (Registration Number (UEN): 200007942R) in Singapore.

This material has not been reviewed by any regulatory authority in Hong Kong or Singapore.

All Investors in the People's Republic of China ("PRC"):

This material is provided by Legg Mason Asset Management Hong Kong Limited to intended recipients in the PRC.  The content of this document is only for Press or the PRC investors investing in the QDII Product offered by PRC's commercial bank in accordance with the regulation of China Banking Regulatory Commission.  Investors should read the offering document prior to any subscription.  Please seek advice from PRC's commercial banks and/or other professional advisors, if necessary. Please note that Legg Mason and its affiliates are the Managers of the offshore funds invested by QDII Products only.  Legg Mason and its affiliates are not authorized by any regulatory authority to conduct business or investment activities in China.

This material has not been reviewed by any regulatory authority in the PRC.

Distributors and existing investors in Korea and Distributors in Taiwan:

This material is provided by Legg Mason Asset Management Hong Kong Limited to eligible recipients in Korea and by Legg Mason Investments (Taiwan) Limited (Registration Number: (98) Jin Guan Tou Gu Xin Zi Di 001; Address: Suite E, 55F, Taipei 101 Tower, 7, Xin Yi Road, Section 5, Taipei 110, Taiwan, R.O.C.; Tel: (886) 2-8722 1666) in Taiwan. Legg Mason Investments (Taiwan) Limited operates and manages its business independently.

This material has not been reviewed by any regulatory authority in Korea or Taiwan.

All Investors in the Americas:

This material is provided by Legg Mason Investor Services LLC, a U.S. registered Broker-Dealer, which includes Legg Mason Americas International. Legg Mason Investor Services, LLC, Member FINRA/SIPC, and all entities mentioned are subsidiaries of Legg Mason, Inc.

All Investors in Australia and New Zealand:

This document is issued by Legg Mason Asset Management Australia Limited (ABN 76 004 835 839, AFSL 204827).  The information in this document is of a general nature only and is not intended to be, and is not, a complete or definitive statement of matters described in it. It has not been prepared to take into account the investment objectives, financial objectives or particular needs of any particular person.

Forecasts are inherently limited and should not be relied upon as indicators of actual or future performance.