One of the firms that we like to follow closely here at The Acquirer’s Multiple is O’Shaughnessy Asset Management (OSAM), which is run by Jim and Patrick O’Shaughnessy and their team.
OSAM recently released it Q218 Shareholder letter which provides some great insights on the future of value investing and why OSAM will continue to use value factors as the cornerstone of their value investing strategy saying:
“We will continue to use value factors as key inputs into our models, because the evidence and our intuition tell us that positioning in securities characterized by lower expectations provides an edge for long term investors, even if the standalone factor trudges through long winters of underperformance.”
Here’s an excerpt from that letter:
In this quarter’s letter, we’re going to share our thoughts on three key topics: the Value factor’s extended run of poor performance, the ways we believe asset managers can borrow concepts from the technology sector, and our current research agenda.
The Value Winter
Is Value ever going to work again? Since 2010, the Russell 1000 Growth index has outperformed the Russell 1000 Value index by roughly 70%, leaving many investors wondering if Value’s historical edge will persist, or whether, instead, the future will be more random.
Since 2010, growth stocks like Apple, Amazon, and Facebook have dominated. Value stocks like Exxon, Bank of America, and Proctor and Gamble have lagged significantly.
But this has not been a trend concentrated among just a few stocks. Growth outperformed value in every single sector. The results were most pronounced in Energy, Tech, and Consumer Discretionary—but even within the Telecom, Materials, and Real Estate sectors, growth beat value. Here is the total effect within each sector (the result of stock selection and allocation):
These sector results are only useful in hindsight, and there is almost no chance that the next 8 years will look the same. Still, they are a useful way of illustrating how pervasive this trend has been.
Perhaps a more interesting angle is to parse the drivers of returns using a framework we introduced in our paper “Factors From Scratch.”
It is difficult to explain fundamental performance within the Russell style indexes, because there is significant turnover each year. In this animation, we show in red companies which are switching indexes on rebalance dates, and in green companies which are entering into an index for the first time.
*For the best visual version of this chart and letter, please visit the Blog & Research section of www.osam.com
In Factors From Scratch, we introduced a method for decomposing index returns in the presence of that turnover. Specifically, we identified three sources of return for high-turnover indexes:
■ Holding Period EPS Growth – growth in the underlying companies during the holding periods.
■ Rebalancing EPS Growth – growth due to multiple expansion that gets removed from the index via rebalances back into cheaper stocks.
■ End to End Valuation Changes – Valuation changes that do not get removed via rebalances, but that instead stay in the index over the entire period of the analysis.
Typically, growth stocks have much better holding growth, but trade into more expensive stocks on rebalances, resulting in poor rebalance returns. Value stocks, by contrast, have weaker holding growth (the companies are often in distress), but make up for it via trading down into cheaper stocks and riding multiple expansion during the holding period.
Here is how the Russell indexes have looked over the very long term:
Notice the trade off. In the growth index, you “pay” for very strong holding growth with “expensive” rebalances: the Russell 1000 Growth, on average, trades into more expensive stocks. In the value index you “get paid” for owning weaker companies (not literally, of course, you just get to pay a cheaper multiple, which the market has historically re-rated higher in the year after purchase, delivering you a strong rebalance return). It would be great to get high growth at a cheap price, but it doesn’t work that way. There is a balance between value and growth. Historically that balance has slightly favored value.
But now look at this same data since June, 2010:
Even in a period of above average returns, value’s holding growth has been far worse than historic norms. Russell 1000 Value stocks have often been cheap for good reason. Think here of the major energy companies, like Exxon Mobil, which have represented among the largest weights in the index. Growth, meanwhile, has performed more in line with its historic norms, showing similar rebalancing and holding returns.
Both strategies have benefitted from strong end-to-end valuation changes, as the market is much more expensive in 2018 than it was in 2010. But relative to value, growth has benefitted more from this end-to-end multiple expansion, gaining an additional 1.5% per year (5.05% per year for growth vs. 3.46% for value from that effect).
The higher return from end-to-end multiple expansion for the Growth index reflects the fact that it has received a boost from becoming more expensive relative to history. If this increased expensiveness were to unwind going forward, the prior source of added return will turn into a drag.
As investors, we want to pay unfair prices for future per share fundamental growth and cash flows. If you knew future growth, you’d be an invincible investor (so long as you didn’t use leverage), because you could compare today’s prices with future growth and pick the better opportunities. Value has beaten Growth historically because while holding growth isn’t great, the price you pay for Value has been unfair (i.e., too low).
That has not held true since 2010. To summarize the findings through this lens: this period hasn’t been an abnormally strong run for growth companies. Instead, its been a very bad period for the EPS growth of value stocks.
The Future of Value
If the value factor is going to work in the future, it will be for the same reasons that it has worked in the past: rebalancing return (our way of tracking multiple expansion across rebalances) will prove strong enough to overcome relatively lower holding growth. The ability to swap into cheaper stocks at each rebalance and hold as their multiples expand will make up for weaker holding return and lead to real excess return. The conditions for strong rebalance growth are present in today’s market. What remains unknowable is whether the cheapest stocks will continue to have very weak growth during the holding period.
While we’ve spent a lot of time thinking about value, it is important to note that we don’t advocate single factor investing. We believe better results come when you thoughtfully combine many signals into an overall model, and construct a portfolio with much more rigor than the “highest ranking quintile” approach used in most academic papers.
We will continue to use value factors as key inputs into our models, because the evidence and our intuition tell us that positioning in securities characterized by lower expectations provides an edge for long term investors, even if the standalone factor trudges through long winters of underperformance.
You can read the OSAM’s Q218 Shareholder Letter here.
For more articles like this, check out our recent articles here.
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