These are tough times for the venerable value strategy.
It has a storied history. The evidence of reliable stock market data dating to 1926 shows that the policy of going long on cheap and short on expensive stocks, popularised by legends like Benjamin Graham and Warren Buffett, has rewarded patient investors.
One might hesitate to say value has ever been ‘in fashion’. Taking the time to research humdrum shares in unglamorous market sectors, and waiting for years for them to come good – if they ever do – lacks the thrill of surfing momentum stocks.
But the philosophy has been particularly unloved over the past 15 years, left in the dust by the runaway success of market cap index funds powered by a cluster of stellar growth stocks, the ‘magnificent seven’ that accounted for more than half of the S&P 500’s returns last year.
Value trailed growth in the all important US market by 50% through the 2010s. It rallied briefly as the world economy moved beyond the pandemic, but was blown away again as the market became enraptured by the possibilities of AI. The value factor is down 11% in the US since ChatGPT debuted in late 2022.
Value beyond the US
But something rather obvious is often omitted from this story, hiding in plain sight: beyond the US the value strategy seems to be working just fine. A lucid Financial Times article earlier this summer by Daniel Rasmussen, CIO of Verdad Advisers, pointed out that since March 2020 the value factor is up 36% in developed ex-US markets. Indeed it has outperformed over three, five, 10 and 15-year periods. Perhaps the underperformance of value in the US is historically contingent. US markets will fall into line and patient value investors will once again be rewarded for their virtue.
Perhaps. Much, it would seem, depends on the capacity of the companies to continue to ride breakthrough technologies such as cloud computing and AI that have allowed them to expand across the world with near zero marginal costs, increasing profits at unprecedented rates and attracting oceans of capital from investors.
The conditions for continued outperformance seem to be in place. Years of dominance have allowed them to refine their competitive advantages: consider Tesla’s production of lithium-ion batteries or Nvidia’s cutting-edge chips. The platforms through which they monopolise their respective markets allow them to benefit from cascading ‘network effects’ through platforms monopolising their respective market, the power of which was recently illustrated by X’s ability to hold off credible competition from Threads by virtue of its established user base, despite much unease about the changes introduced by new owner Elon Musk.
Big tech’s seemingly limitless pockets allows it to commit billions to research to maintain it edge. New ideas, products and services generated through ‘recombinant innovation’ have opened previously unexpected avenues of revenue, notably Amazon and Microsoft’s realisation that their massive server infrastructures could be put to use to usher in today’s era of cheap cloud computing. And the magnificent seven’s capacity to invest in the best brains means they are in pole position to reap early gains from the progress of AI.
Value and the weight of history
For Rasmussen, however, the history of how innovation has played out in the markets indicates that big tech will - ultimately - be reigned in by the force of competition. Referring to a 2017 paper by Leonid Kogan, Dimitris Papanikolaou, Amit Seru, Noah Stoffman, studying waves of innovation over the past 150 years, he argues that competitors eventually adjust to new environments, and win new capital.
It happened after the advances in electricity and railways that drove the second Industrial Revolution in the mid-to-late 1800s; it happened after the manufacturing and chemicals breakthroughs in the 1920s and 1930s; and it will happen after this most recent wave, the digital innovations since the 1980s. The fundamental law of value investing holds: to survive value stocks must take action to offer investors above-market rates of return over the long run. While initial equity returns flow to innovators, the longer-term benefits accrue to the customers of that technology, and to the myriad of firms offering it.
Kogan et al found that throughout these waves of innovation large growth stocks compounded at 9.7% per year, but that small value stocks compounded at 13.8% per year, compelled to produce above-market returns over the long run. History shows that markets tend to adapt to technological shifts.
Rasmussen argued that today’s extreme valuation spreads set the conditions for an even bigger correction. Current conditions in the US market, with a cyclically adjusted price-to-earnings ratio of 34x, are even more extreme than on the eve of the Global Financial Crisis, when it was 29x. Faith in the value strategy is, in the end, faith in competition – capitalism’s continued ability to generate growth.
The value of equal-weighted funds
So, should investors favour value-weighted funds? If, perhaps, they have faith, patience and plenty of years to accumulate returns. The history of the markets indicates patterns, but not laws. Current conditions may be such as to allow big tech to continue to make big gains for some time to come. It should be noted that Rasmussen has an interest: Verdad is known for its focus on small cap value stocks.
One alternative to an explicit value strategy, discussed this year by ETF Stream, is to use equal rather than market cap weighted funds. By reducing exposure to momentum, equal weighted funds have a natural bias towards value. As their market caps drop relative to their earnings and size, former growth stocks become value stocks. By widening the net to trawl stocks of every size equal weighted trackers come good over time. Since it was launched just over 20 years ago the S&P 500 Equal Weight index has delivered annualised returns of 11.5% against 10.3% for the market-cap weighted benchmark.
Not all are convinced. Elroy Dimson, professor of finance at Cambridge Judge Business School, speaking at ETF Stream’s ETF Ecosystem Unwrapped, panned equally weighted indices as an ‘appallingly bad idea’. Rebalancing over time means they “sell the winners and buy the losers to get back to equal weight”. For Dimson the risk of overconcentration is overplayed: “Apart from Japan, everyone else has a more concentrated market than the US.”
A plausible compromise, suggested by behavioural investment blogger and fund manager Joe Wiggins, is to split passive allocation between market cap and equal weighted funds. If one is historically cheap or expensive relative to the other there may be an opportunity to improve future returns. When index funds are outperforming their equal weighted counterparts it might be prudent to increase allocation towards the latter, and vice versa.
As ever with investment there is no magic formula. We do not know if the big companies will sustain performance. We do not know what impact AI will have. We do not know how long until the value strategy will come good again, or how good that good will be. Finance is best studied through the lens of history rather than science. A hedging strategy as advocated by Wiggins has appeal, but given our chronic uncertainty it is perfectly reasonable for investors to be allocated entirely to market cap weighted funds. But not, maybe, to think that is the only strategy worth following.
Justin Reynolds is a freelance journalist and editor of The Patient Investor blog
This article first appeared in ETF Insider, ETF Stream's monthly ETF magazine for professional investors in Europe. To read the full edition, click here.
