VALUE: After Hours (S07 E17): The Value vs Growth Debate Revisited

During their recent episode, Taylor, Carlisle, Schwartz and Hanauer discussed The Value vs Growth Debate Revisited. Here’s an excerpt from the episode:

Tobias: Let’s talk more broadly. What do you think investors who are approaching this problem now, what’s a sensible approach for them into the future? Does the deterioration in value mean that– is that cyclical because it looks a little bit secular in that data or do you feel like it’s cyclical? God, I hope it’s cyclical.

Jake: Disgusting. [laughs] No dog in this race, but yeah.

[laughter]

Matthias: I didn’t look at it in this paper, but I have other publication and inside articles where I look at value investing, in general. I think value had a strong period in the early 2000 after the dot-com bubble. During the dot-com bubble or the buildup of dot-com bubble, it also had problems. When we zoom into this period, 2018 to 2020, then the similarities to 1999 were quite similar. So, value mainly underperformed, because already expensive stocks became even more expensive, and already cheap stocks became even more cheap. If you’re investing in these cheap stocks and they’re getting cheaper, then it’s bad for your realized returns.

But the more wide this valuation spread, how we call it– I think you also shared some updates on that. Actually, it should be more promising to invest in these stocks. We saw that this partly paid off in 2021 and 2022, and the valuation spread came down over this period. It’s not as low as it used to be in 2015. So, I think we have still some lag to go from the valuation perspective.

But it’s also important to note that value, maybe even it is like smaller returns in the past or even have its neutral returns, it can be still a great diversifier to quality or momentum, because it tends to be negatively correlated. Even if the premium is zero, it could for instance lower the volatility of a strategy. But I would expect like a positive return, maybe not as high as in the 1980s or whatever, but still I would expect a positive return on value.

But you should blend it with also other factors and to lower the tracking error, because what we also saw in the paper, in the long run, these investing formulas give you a premium. But there also are periods where you really have to pay. We measure this via drawdowns. You saw the drawdowns around the global financial crisis, but also in 2018, 2020.

We not only look at relative drawdowns, but we also look at absolute drawdowns. We also saw that The Magic Formula, Acquirer’s Multiple F-score, they behave more similar because they are essentially like value quality mixes. Maybe the conservative formula is the most distinct one, because it has this low volatility element which leads that you maybe lack in really strong bull market, but it gives you the best downside protection. By further including momentum and net payout yield, you also higher the long-term premium.

Tobias: Do you find it a little bit unusual that the low volatility generates lots of performance when it flies in the face of the entire basis for the efficient markets theory that high volatility that it’s working 180 degrees against what the orthodoxy is.

Matthias: Well, we should have invited Pim van Vilet for that. [chuckles] So, he came up with this conservative formula, and he also provided great feedback when we saw the draft and gave a lot of input. So, especially, we want to thank him here. I think this is really the core of all these factor models that typically people extended the CAPM with size value, later profitability investments. But they always kept the relationship that higher market beta should lead to higher returns.

But actually, it’s the opposite that the relationship is not linear. There’s a little difference between beta low-risk stocks and medium-risk stocks. But there’s really a cliff where really the stocks with the highest beta with the highest volatility, they really underperform the market, and these are the stocks that you should maybe avoid.

Tobias: I asked this question on Twitter a few years ago now, so I can’t really remember what the answer was. But someone had done some research showing that the higher the volatility, the worse the returns. It wasn’t Pim. It was a little bit before then. I wondered when they were getting their Nobel Prize for Economics, because I think they’re probably due for one. I don’t think that there’s been any movement in that direction given that it breaks down the entire structure that’s taught in just about every university in the world and has been for 50 years.

Matthias: With the five-factor model, they somehow can explain the high minus low volume or high minus low beta returns in the time series regression. But I haven’t seen any evidence, for instance, that in a cross-sectional Fama-MacBeth regression that beta became positively priced. So, I think they’re still not convincing evidence that maybe including other factors than this relationship really holds.

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