"Value has been crushed over the past decade," admits John Ameriks, head of Vanguard's quantitative equity group. "There’s no magic strategy that's always going to work. But if you believe in this flavour of investing, it's been getting more attractive on a go-forward basis."
Buying cheap stuff that stinks can be the best investment in the world
It has not been easy to be a value investor lately. The Morningstar US Growth Index has whipped the Morningstar US Value Index during the past several years, and things have been especially rough this year.
"The world is unfolding exactly as it should," added John West, managing director at Research Affiliates. Almost any factor or style of investing goes through 10 years of underperformance. To invest in any particular style, you need to go in with very a long-time horizon, he noted, at least 10 years.
"The expected return of this strategy is 2% plus or minus 10%," said West. Those unwilling to accept this possible range of returns in any given year should not engage in value investing.
Along with a long time horizon and an ability to accept a wide range of returns, investing in value strategies requires the fortitude to invest in uncomfortable stocks, those that other investors will not touch.
"You've got to own the pain, you've got to buy the cheap stuff everybody hates," argued Wes Gray, CEO of Alpha Architect. "You've got to own all this stuff that Amazon (AMZN) is going to rip off the planet. It's not like Macy's is going to kick Amazon's butt, but Macy's may not go bankrupt. Buying cheap stuff that stinks can be the best investment in the world."
And that's the premise behind value investing: cheap stuff outperforms expensive stuff over the long term. But what metrics are best to use to determine what's cheap: price/book, price/earnings, price/sales, or some combination thereof?
"There's no one right way to be a value investor," said Ameriks. The right metrics may depend on what company, type of stock, or sector you're considering.
"We try to use a broad array of measures," noted West. Further, the typical value metrics tend to track each other over the long term.
Some value managers will overlay additional criteria say, a quality screen or a maximum sector percentage to the process, in an effort to thwart risk and perhaps add a bit of extra return.
"You have to start with value, with the stuff that's uncomfortable," reminded West. "And then if you want to focus on higher quality, go ahead and maybe you can get some incremental improvement in return."
Though, conversely, adding too many layers of criteria can dampen the effectiveness of the value effect over time.
"It gets much harder as you add additional overlays," noted Ameriks.
Gray noted that the more you sector-neutralise, the less you're capturing the value premium.
"Anything related to Amazon is a value stock, retailers are correlated today," he said. "If it's all cheap because it's in Amazon's path, you need to own a lot of it."
Rather than adding too many overlays, value investors can instead diversify across a large number of stocks or own bigger rather than smaller companies, though the panellists at the Morningstar ETF Conference agreed that, in general, most factors are more effective with small-cap stocks, due to less information and efficiency in that part of the market.
"The concept of not overpaying makes sense in large caps and small caps," noted Ameriks.
Though value investing can be trying at times, it's a common-sense strategy rooted in one basic investing principle: as prices go up, expected returns go down.
"It's called maths," concluded Gray.
