The History of Value Investing
Earlier this quarter, we talked about the nature of value investing and why it works. Value investors focus on qualities intrinsic to a business – in lieu of external factors – and they pay attention to market prices only to the extent that they present opportunities to buy shares at large discounts to estimates of their inherent worth.
During the past several years, value investing has underperformed the major indexes. However, since 1962, a hypothetical portfolio based on one of the most widely researched value approaches (1) would have grown almost 10 times more than the same money invested in the S&P 500. That is, while value investing has not performed well over the short run, it would have done exceptionally well over the long run.
So, perhaps the right question is: does value investing still work? It turns out that, despite value investing’s strong long-term returns, you might have asked that same question in 1966, 1973, 1980, 1991, 1999, 2003, and 2009. At those times, the same value approach behind the returns described above would have underperformed the S&P 500 for multiple years, in some cases by more than 30%.
The chart above illustrates this point well. The top section shows the hypothetical cumulative returns of the value approach versus the S&P 500 total return (i.e., price appreciation plus dividends) between 1962 and September 2015. The ending capital numbers are $1,371 for the value approach and $140 for the S&P 500 – hence, almost 10 times more capital. The bottom part of the chart shows the drawdowns of the value approach relative to the S&P 500 (2).
Clearly, there have been many long periods of underperformance for value investing despite its long-term success. In fact, we are currently in the midst of such a period. But what happens when these periods end? To answer that question, we plotted the two-year hypothetical return of the value approach starting from the trough of the largest six relative drawdowns since 1962. The result is the chart below.
While it may seem obvious that the relative returns of this value strategy might be strong once its relative performance turned around, the charts also show that there have been strong absolute returns realized in each value recovery.
When value investing underperforms, cheap companies become relatively less expensive as they continue to lag behind the market, and opportunities emerge when the share prices of certain out-of-favor companies fall below their estimated values. During periods resembling this in the past, share prices eventually adjusted back toward companies’ intrinsic values, resulting in strong absolute returns for value investors and relative disappointment for those pursuing indexed strategies or owning expensive stocks.
Would you like to reproduce these results in the R programming language? Click here to get the code that generates the charts. Or clone the github repo email@example.com:euclidjda/research-blog-posts.git to get the code from many of our posts.
The historical results represented herein are for illustrative purposes only and are not based on actual performance results. The hypothetical portfolio and the associated returns do not reflect the effect of transaction costs, bid/ask spreads, slippage, or management fees. Historical results are not indicative of future performance.
1) Kenneth French’s website archives maintain many time series of returns related to fundamental investing. One such monthly time series represents the returns of ten portfolios formed by sorting the universe by each stock’s ratio of book equity to market value and splitting them evenly into deciles. The weight of each stock in each portfolio is proportional to the stock’s market value. In our analysis, we use the portfolio with the highest book equity to market value as the “value approach.” The specific file for these returns can be found here. In this analysis, the S&P 500’s total returns (market appreciation plus dividends) were computed using data from Standard and Poor’s COMPUSTAT database.
2) We construct the drawdowns of the value approach relative to the S&P 500 as follows. We form a time series by subtracting the monthly S&P 500 total returns from the monthly value approach returns. This time series represents a hypothetical fund that has bought long the value approach and sold short the S&P 500. When the value approach outperforms the S&P 500, this hypothetical fund goes up, and when the opposite happens, it goes down. Therefore, a drawdown of this hypothetical fund represents a period where the value approach is underperforming the S&P 500.