The current investment environment, with its apparent disconnect between economic and financial conditions, has been discomfiting for some of the world’s most famous investors. “Has Warren Buffett Lost His Mojo?” the Financial Times asked this week, accusing the Sage of Omaha of poor timing and awful stock picking. Two hedge fund titans, Paul Tudor Jones and Stan Druckerman, recently both owned up to be out of sync with the markets. Druckenmiller apologized for being “far too cautious” and having “missed a great opportunity.” Jones, speaking to The Economic Club of New York, said: “If there was a franchise for humble pie, oh my lord they’d be a mile long to own that, because we all had huge gulps of it — me included.” And, now, Jeremy Grantham, the modern doyen of value investors, has said that, even though “value” stocks have had a epic run of poor performance, “this time may be different” and he is not confident that they will bounce back. Grantham warns that cheap stocks are cheap for good reasons and investors should be careful before selling the high-flying FAANG stocks which are driving the markets upwards.
Grantham is a founder of GMO, a Boston-based asset management firm which has made its reputation over many decades by sticking to its value methodology through cycles. Grantham’s brilliant essays on investing have been required reading for a generation of “value” investors.
Value investing – defined as stock-picking based on quantitative metrics of cheapness (price-to-book, price-to-earnings, price-to-sales, etc…) — has been a very successful strategy over the years. The superior performance of value stocks over time — the value premium – is well documented in academic research. However, over the past ten years, the strategy has lagged badly, raising claims of “the death of value.”
Grantham’s Case for “This Time is Different.”
In the past, value investors would relish a period of underperformance, believing that mean reversion would work its magic. However, this time Grantham is not convinced. Even though this crisis is the “fourth major event” of his career and the previous three created enormous opportunities for value investors, Grantham thinks this one is the most “uncertain” because the world may have fundamentally changed.
In a very thoughtful interview on the “Invest Like the Best Podcast” (Link) Grantham says that the value premium of the past may have been a temporary aberration. Value stocks are cheap as a reflection of the market’s disgust and there is no intrinsic reason that they should provide higher returns, Grantham says. The strategy worked in the past because:
“The general caliber of competition back in those days was very weak and therefore if you did decent analysis, looked for value you could find it. So we were able to build simple mechanistic models by giving points for cheap book and so on and have a win on a very broad basis, so we could manage a lot of money. And we were winning 2 out of 3 years and adding a few points on average per year.”
However, that era came to an end about 20 years ago, according to Grantham. The “simpleminded” nature of the strategy was made evident by academic research and arbitraged away by quantitative investors:
“Too many machines were picking it up, too many quants, too much money, and pretty soon the historical aversion to cheap stocks had disappeared because they acquired the reputation for having won. The quants made it clear they understood that for 1800 years into the mist of time these were factors that worked, and indeed academics wrote it up and got a lot of credit for such a simpleminded idea.”
Moreover, several other factors have contributed to making the investment environment less friendly for value investors, Grantham says:
- The U.S. has drifted away from a healthy capitalistic system, experiencing a gradual increase in the power of big corporations: “the degree of corporate influence over government and regulation has climbed which facilitates monopoly. The willingness of the justice department to break companies up has declined, not surpringly, under those conditions.” This has resulted in a a “weakening in competitive spirit and speed. Conservatism and high return is put ahead now of growth and being the first and the biggest at something new.”
- The Federal Reserve has become a dominant presence in the markets. In the past, value investors could ignore the Fed in expectation that the market would self-correct, but now the Fed rules the market.
- The market leaders today – the FAANGs (Facebook, Amazon, Apple, Neflix and Google) – “ are unlike anything that ever walked the face of the earth. They generate market cap out of thin air, their use of assets is unlike anything it used to be; it’s not about traditional capital being depreciated and replaced and cranking out widgets, it’s all about intangible capital and brand and speed and using your brains to innovate.”
How much of an aberration is value’s recent underperformance?
In a recent paper, “Factor Performance 2010-2019: A Lost Decade? “ David Blitz, Head of Quantitative Research at Robeco in the Netherlands, argues that the recent troubles of value are not unusual. Value’s poor results over the past decade are typical when the market is very strong and dominated by other factors such as momentum and profitability. As the table below shows, value also performed poorly in 1990-1999, a similar period when the stock market was driven higher by high-growth technology stocks. The data is from the Kenneth French Data Library.
The chart below is from Your Complete Guide to Factor Investing by Andrew Berkin and Larry Swedroe, which looked at the data for a 90-year period, through 2017. On the right side, we can see the value premium harvested over this period. It is important to see the premiums in the context of the data on the right side of the chart which shows the probability of negative premiums over different periods. We can see that value has had a 14% chance of providing negative premiums over any 10-year period, and a six percent chance over any twenty-year period.
Therefore, long periods of negative premiums are not extraordinary. Moreover, we can probably say that these periods of underperformance are a necessary condition for the factor to work over time, because we should not expect anything easy to work in investing. Therefore, “no pain, no gain,” and one should not expect to harvest the value premium without facing the risk of long periods of failure.
The “Death of Value” and Emerging Markets
It is no coincidence that emerging market stocks and value have both performed very poorly over the past decade. To a considerable degree, they are tied at the hip, both representing exposure to more risky and more cyclical segments of the market (though this has been somewhat mitigated in recent years with the rise of Chinese tech stocks). The chart below shows the annual returns by decade for emerging market stocks and the S&P 500, since the launch of the MSCI EM Index at the start of 1987. If we compare these returns with those from the first chart from the Robeco paper, we can see that EM stocks and value both perform relatively well in decades when the S&P 500 does poorly. Both value and EM are “risk-on” trades, that do poorly in those decades of “American Exceptionalism” when investors are enamored with American growth stocks. We are coming out of such a decade, when the FAANGs, turboed by record-low interest rates, have dominated the markets.
No surprisingly, EM value stocks have done even worse over this past decade, as can be seen in the following chart, which compares the returns of the FTSE-Russel EM Index with that of the Dimensional EM Value Fund.
In conclusion, investors in emerging market stocks must hope that Grantham is wrong and that “This time is different” continues to be the four most dangerous words in the English language, as Sir John Templeton once said.
This hope is founded on the expectation that a combination of the following events will materialize:
- The FAANGS will peter out, weighed down by valuation, size and regulatory pressure.
- American Exceptionalism will take a rest.
- The U.S. economy will slow, the dollar will weaken and commodity prices will rise.
- Global growth will accelerate relative to the U.S. economy.