Is value investing in trouble?

Value investing has not worked well over the last five years. This is a long period of underperformance and raises the question of whether value investing is the right investment approach in the current market.

Value investing is usually defined as buying shares that are trading on low price to earnings (P/E), low price to book (P/B) or any other low price/denominator. This is quite a simplistic definition of value investing, but even this simplistic investment strategy (if applied consistently) has delivered superior returns of approximately 2% to the broad stock market over very long periods of time (as depicted in chart 1).

“The key word here is ‘consistently’”, says Razeen Dinath, senior analyst at Momentum Asset Management. “The reason for this is that value investing can underperform for long periods of time. As mentioned previously, the current period of underperformance has lasted five years.”

However, this is not the time to lose conviction. The long-term evidence is firmly stacked in favour of value investing. Table 1 sets out the 10-year returns for the S&P 500, based on the starting Shiller P/E from 1926 to 2012, and it is clear that paying a low price leads to good 10-year returns. The earnings number in the Shiller P/E is calculated by taking the average of the last 10 years’ earnings per share (EPS), adjusted for inflation. The Shiller P/E is considered a more reliable valuation metric as the average real 10-year earnings number is not significantly affected by sharp increases or declines in the one-year earnings number.

Unfortunately, the current Shiller P/E is over 25, so the 10-year returns from this point forward are not attractive. When prospective return expectations are low, investors should be cautious and lower their equity exposure.

Value investing has also outperformed growth investing over the long term (although not in the last five years) because, contrary to popular belief about efficient markets and rational pricing, the market is not always efficient and often overreacts to good and bad news.

This overreaction causes the share price to move above or below the value of the business (the value of the business is the present value of all future cash flows that the business will generate). “Value investing exploits the market’s overreaction by paying less for the future cash flows than the present value, which leads to excess returns,” adds Dinath.

The underperformance of value investing in relation to growth investing (and the market) over the last five years is also evident for South Africa’s JSE All Share. We do not know whether this recent cycle of value underperformance is going to persist, but we do know that value investing is the correct investment approach for superior long-term returns. We do not know where the market will be in six months, one year or more, but we do know that buying businesses for less than what they are worth will produce the desired outcome in the long run.

Value investing is not in trouble, it’s just not working right now and these periods of underperformance lead to eventual capitulation by managers and clients who have less conviction in the merits of the approach. Value investing has produced excellent long-term results and we believe that it will continue to do so. “The discomfort of looking wrong for long periods of time is the cost that a value investor has to bear to produce the long-run outperformance and the key is to implement this investment approach on a consistent basis,” concludes Dinath.