Is Value Investing Dead?

by: Lyn Alden Schwartzer

The Russell 1000 Value Index has underperformed the Russell 1000 Growth Index over the past 12 years.

However, value stocks are now at the deepest discount to growth since 2000, potentially providing a nice setup.

Many stocks that offer a blend of value and quality seem well-positioned at the current time, but value investing won't be as simple as it was in earlier eras.

A large portion of the world's most successful and famous investors have been value investors, meaning that they buy cheap out-of-favor companies (aka "value stocks") and prosper as those companies continue to perform fundamentally well against market consensus.

For this to work, either the company remains cheap and goes on to spend money on huge dividends/buybacks year after year, or the company eventually gets re-valued at a more appropriate higher valuation as the market realizes its previous short-sighted mistake.

A good example of a historically successful value stock is Altria (MO), the parent company of Philip Morris USA. When evidence started to come out about how unhealthy smoking was, and smoking rates began dwindling, investors assumed that cigarette makers would struggle, and thus gave them low valuations. The fundamentals of those companies remained surprisingly strong, though.

This, ironically, gave many cigarette stocks outrageously good returns because the stocks had much higher sustainable dividend yields than they should have had based on their fundamentals, so investors that kept receiving and reinvesting their dividends did very well. The companies themselves also reinvested some earnings to buy back super-cheap shares and boost their earnings-per-share and dividend-per-share metrics.

This chart says quite a bit by itself:

Chart Data by YCharts

The problem is that now investors know that value stocks historically outperform most other factors, so humans (and the machines they program) can easily go around buying the cheapest value stocks on the market (specifically the stocks with the lowest price-to-earnings or price-to-book ratios), which drives up their valuations and potentially eliminates their alpha.

Likewise, many growth stocks have been disrupting value stocks. Some of the lowest-valued stocks today are banks, asset managers, retailers, fossil fuel companies, and so forth. Meanwhile, growth stocks like Amazon, fintech companies, and renewable energy companies are trying to take their lunch, and in some cases succeeding.

So is value investing dead? Growth stocks have been crushing value stocks for several years now. Or do we need to reconsider what the definition of value is?

Growth And Value Are Historically Cyclical

A lot of people search for terms like, "best value stocks 2019" or "cheap stocks to buy", but let's take a more examined approach of value and its history before diving into value stock picks.

The relationship between value stocks and growth stocks has been an interesting long-term cycle over decades.

The following chart shows the Russell 1000 Value Index divided by the Russell 1000 Growth Index. When the line was going up, it means value was outperforming. When the line was going down, it means growth was outperforming:

Chart Source: St Louis Fed, FTSE Russell

From 1980 to 1988, value mildly outperformed growth. From 1988 to 2000, growth mildly outperformed value. From 2000 to 2007, value crushed growth. From 2007 to present, growth has moderately outperformed value.

This can happen for many reasons. Money tends to pour into what has been doing well. When value does very well as a factor, for example, investors and institutions will happily put more money into value stocks and value funds. But eventually, the valuations on value stocks aren't even that cheap anymore, so the strategy underperforms.

Likewise, when people get excited about growth stocks, they can reach such crazy valuations that they have nowhere to go but down because they are totally unjustified by their fundamentals, like in the year 2000.

In addition, there are disruptive forces at play due to new technology or other aspects that allow some periods to see a greater fundamental rise of growth stocks than others. This past decade has seen a gargantuan rise of tech giants, with Apple inventing the iPhone in 2007, Alphabet taking over the internet, Amazon dominating the retail and cloud spaces, and Microsoft continuing to do well in enterprise and cloud platforms. This has been a more fundamentally-driven period of outperformance for growth stocks than the run-up to the dotcom bubble was.

But the question remains, is value dead or just dormant? Will it start a new cycle of outperformance, or no?

My opinion, based on the stocks I research, is that the blend of quality and value should do pretty well going forward. In addition, I think investors need to take a global view if they want to find true value, because many of the deepest bargains are outside of the United States.

Even in the United States, however, value stocks are at one of the biggest discounts to growth in modern history:

Value Discount

Chart Source: AllianceBernstein

Quintessential Value ETFs

The Vanguard Value ETF (VTV) and the iShares Russell 1000 Value ETF (IWD) are some of the largest value-tilted ETFs available, and both have rock-bottom expense ratios. At the moment, they are heavily invested in financials, healthcare, and consumer goods.

Comparing the longer-running one (IWD) with the standard S&P 500 ETF (SPY), shows decent results:

Chart Data by YCharts

Past performance is no guarantee of future performance, and as we've seen, growth and value historically outperform each other for long periods of time in huge cycles. Investing with a value tilt may lead to underperformance for a decade only to go on and outperform the next decade, and vice versa.

Smart Beta Value ETFs

The biggest risk of investing in value stocks is the concept of a "value trap".

A value trap is a company that looks cheap and is cheap, but ends up being cheap for a reason and thus the fundamentals inevitably fall apart. Maybe the company has too much debt, or a hopelessly outdated product, for example.

Some of the best value investors screen for quality to filter out those types of businesses.

The most famous example is Warren Buffett. The main improvement he made over his mentor Benjamin Graham (the father of value investing) is that besides just looking for cheap companies, he looked for cheap companies with an economic moat. In other words, he added a quality factor to ensure his value stocks would continue generating strong profits for a long time.

A similar approach has been used with success by Joel Greenblatt of Gotham Capital, which he also popularized with The Little Book That Still Beats the Market.

Greenblatt presents a simple system:

  1. Rank all companies by their price-to-earnings ratio (low to high).
  2. Rank all companies by their return on invested capital (high to low).
  3. Buy the top companies that have the best combination of both (low P/E, high ROIC).

This results in having a couple dozen cheap companies with high returns on invested capital, implying they have a strong business model and economic moat and are unlikely to be value traps. This formula has beaten the S&P 500 for a long time, but like many value strategies has struggled a bit in recent years compared to growth stocks.

Joel Greenblatt's big fund, Gotham Index Plus, is one of the best-performing value funds around. Greenblatt uses a more sophisticated proprietary way to determine value, and invests heavily in the cheapest S&P 500 stocks based on his criteria and shorts the most expensive ones. It has beaten the S&P 500 since inception during a time when value stocks in general have underperformed,

Why ROIC is Important

Greenblatt gives a simple example in his book for why ROIC is important, summarized by me below:

Suppose that a chocolate shop company can invest $400,000 to open up a new chocolate shop location, including remodeling a location, buying product and equipment, hiring initial workers, etc. And they have a track record of generating $100,000 per year in profit on average from their locations. That means their ROIC is 25%; for each dollar they invest into a new location, they'll earn an annual rate of return of 25% on it.

Now suppose a broccoli shop company exists, and literally sells only broccoli. It also costs them $400,000 to open up a new broccoli location, because the fixed initial costs are roughly the same. They need to customize their store, buy initial product and equipment, hire workers, etc. However, because broccoli isn't in as much demand, each location only earns $20,000 per year in net income. In this case, their ROIC is only 5%.

The chocolate shop company will grow much, much faster than the broccoli shop company because for each dollar they invest, their rate of return on that invested capital is massively higher. Opening chocolate shops is a far more lucrative use of capital than opening broccoli shops.

Starbucks (SBUX) and Chipotle Mexican Grill (CMG) are two modern examples of companies that generate strong ROIC for each location they open.

It's not too hard to briefly generate high ROIC. The problem is, once that profitable opportunity is known to exist, competitors will come to get a share of it. Too many competitors going after the same returns will generally diminish the returns for each of them.

That's why the concept of an economic moat is so important. Companies that can build some sort of durable defense against competitors, whether it is brand value, inherent cost advantages, network effects, unique real estate, patent protection, or something else, can allow them to generate high annual ROIC for long periods of time.

U.S. Quantitative Value ETF (QVAL)

Gotham Index Plus is a mutual fund rather than an ETF, and has rather high investment minimums.

The ETF that most closely follows Greenblatt's type of strategy (that I'm aware of) is the Alpha Architect U.S. Quantitative Value ETF QVAL, which is not associated by Greenblatt but has a similar approach.

It applies a quantitative filtering approach to find the top 50 companies that have high ROIC, good balance sheets, and are cheap. It has been around for less than 5 years but like many value methods, it hasn't performed great during this period.

Their international version is IVAL, which filters in a stock universe outside of the United States.

Shareholder Yield ETF (SYLD)

Stocks with high shareholder yields are an attractive subset of value stocks, and the Cambria Shareholder Yield ETF SYLD passively filters for them. The foreign version is FYLD.

The shareholder yield of a company is the sum of money it is paying in dividends, spending on buybacks, and repaying debt, divided by its market capitalization.

Studies have shown that stocks with high shareholder yields tend to outperform virtually every other classification of stocks over long periods of time.

This backtest, for example, found that from 1982 to 2015, stocks with high shareholder yields generated nearly 4% better annual returns than U.S. stocks in general.

Source: Meb Faber and Alpha Architects

In addition to generally filtering for value stocks, the emphasis on shareholder yield further filters for companies that have the necessarily catalyst to take advantage of its status as a value stock. In other words, like Altria, companies that pay big dividends or buy back a ton of shares, do fundamentally better when their shares are undervalued compared to when they are more expensive.

And yet like most value strategies, this one hasn't done well over the past 5 years, even though the backtest shows it would have done amazing over a multi-decade period.

It's the long periods of underperformance like these that potentially allow this sort of strategy to work. Just when you think it's dead, and investors abandon the strategy, it'll ironically go into win. That's the optimistic and statistically likely case, at least.

It's impossible to say for sure if this type of filtering will still lead to outperformance these days until perhaps 15 years after inception, but that's about a third of an investor's career and a big opportunity cost if this ends up not working.

This is why factor investing is very challenging. If a factor does well for a while, money starts to pour into it and drowns out the alpha. If a factor underperforms for a while, an investor naturally wonders whether the factor will eventually start working again, or if something fundamentally changed in the markets that will prevent that factor from outperforming in the future, and you won't be sure for maybe 15 years.

3 Value Stocks I'm Buying

I find that qualitatively looking through companies and performing discounted cash flow analysis on them helps determine which factors are likely to do well going forward, rather than strictly relying on backtesting and quantitative filtering.

And I'm interested in factors that haven't done well recently, rather than ones that have. Basically, I ideally want to know what the next cycle of outperformance will be, rather than focusing on what has done well recently.

My investment approach blends individual stocks with passive ETFs, and my portfolio has a bit of a value tilt currently.

More specifically, I tend to focus on wide-moat GARP ("growth at a reasonable price") investing for my individual holdings. In other words, I don't buy too many deep-value names, but I don't pay exorbitant prices for the most popular growth stocks either.

Instead, I focus on companies that have both value (reasonably inexpensive) and quality (economic moat, good ROIC, strong balance sheet, positive industry). Here are three that I'm buying these days:

Lazard (LAZ)

Asset managers are under a lot of pressure as index funds eat into active market share, and both active and passive funds alike face cost-cutting pressures.

Lazard is half asset manager and half investment bank, where it advises on some of the largest mergers, acquisitions, and restructurings in the world. Their advisory business is one of the top in the world, but is subject to cyclicality in the global economy. Additionally, they're one of the relatively few active asset managers that still has positive net inflows during most years.

Its forward earnings are under a bit of pressure but the stock price has already more than priced that in:

Chart Source: F.A.S.T. Graphs

The blue line in the chart represents the firm's historical earnings multiple.

The regular dividend yield is quite high at well over 4%, and the irregular special dividend pushes it up even higher in most years. This company is more about profitability than growth, and doesn't need much growth to provide good returns.

Lazard is based in Bermuda, issues a K-1 for tax purposes, is rather modest in size, is not included in the S&P 500, and so it flies a bit under the radar.

Discover Financial Services (DFS)

Discover Financial Services operates the Discover payment network and card brand, which benefits from the network effect. It's not as widely-accepted as Visa (NYSE:V), MasterCard (NYSE:MA), or American Express (NYSE:AXP), but its acceptance does keep growing over time. In the United States, it's almost as widely accepted as the other three, but it has a lot of work to do internationally to catch up, which is both a risk and an opportunity at this price point.

Chart Source: F.A.S.T. Graphs

The company also operates a growing online bank that keeps costs very low by not having a physical footprint. Their online savings accounts give better interest rates than the average, and serve as gateways for people to get Discover cards and other Discover services.

This value stock has a lot of volatility because credit card debt is one of the more volatile types of debts. Discover, however, weathered the subprime mortgage crisis rather well, focuses on consumers with decent credit scores, maintains enough reserves to absorb major loan losses, and consistently passes Federal Reserve annual stress tests.

I consider volatile dips in Discover to be buying opportunities.

Texas Instruments (TXN)

Texas Instruments may not be as cheap as the other two on this list, but they meet many of my investing criteria. And they're one of the largest holdings in the Shareholder Yield SYLD ETF because they consistently return most of their free cash to shareholders while also growing their business.

The company makes analog circuits and embedded systems for a variety of applications, has cost advantages over its competitors, has a gorgeous balance sheet, and consistently generates double-digit ROIC.

Right now, semiconductors are in a cyclical downturn, which has resulted in large sell-offs in many semiconductor stocks.

After the recent rebound, Texas Instruments has moved up past my target buy price, so I won't be putting any big money into it. However, the price is reasonable enough that I'm still dollar-cost averaging into it within my newsletter model portfolio.

Chart Source: F.A.S.T. Graphs

Investors Should Like Their Stocks Cheap

The dream scenario for most investors is that they buy a stock and then it immediately goes up. Everything feels good when that happens.

But ironically, investors that are in the accumulation phase of their life cycle should hope for lower stock prices. They'll make more money that way.

The better scenario for accumulating investors, despite being emotionally unsettling, is ironically that after you buy a stock, its stock price crashes while the fundamentals remain strong. Especially if it pays dividends, like the companies on my list of 20+ favorite dividend stocks.

Consider the following example, which is similar to an example that Warren Buffett used years ago.


A stock makes $1/year in EPS currently, and its EPS grows by 7% per year. Additionally, it pays out a 75% dividend yield, so that's $0.75/share for the first year which also grows by 7% per year. You invest $10,000 into the stock at a price-to-earnings ratio of 20, so you buy 500 shares at $20 each.

In Scenario A for this example, the stock forever remains at a 20 P/E ratio, so your share prices go up by 7% per year, and you reinvest your dividends to continually buy more shares. After 25 years of holding the stock and reinvesting dividends, you'll have 1,255 shares worth a total of $127,325, and you'll be earning $4,774 in annual dividends from your shares.

For Scenario B, you buy the exact same stock at the exact same price. However, during sometime in the first year, the market loses interest in the stock and it drops to a 10 P/E ratio, and forever remains at a 10 P/E ratio. The fundamentals, however, are the same. After 25 years of holding the stock and reinvesting dividends, you'll have 3,049 shares worth a total of $154,665, and you'll be earning $11,599 in annual dividends from your shares.

These scenarios are for the exact same stock bought at the exact same price, but the scenario where it crashes 50% soon after and remains at a lower valuation ultimately results in more money for the investor in the long run.

Here is the chart for the portfolio value of both scenarios. Starting on year 20, the dollar value of the Scenario B catches up and surpasses Scenario A:

Value Stocks Example Chart

And here's the chart for annual dividends. Right from the beginning, Scenario B starts generating more dividend income, assuming it is continually reinvested into buying more shares:

Value Stocks Dividend Example

In this case, the value investor doesn't need the market to re-value the stock back up to a higher multiple. The longer it stays cheap, the more shares the reinvested dividends will accumulate, and this would positively affect company share buybacks as well.

On top of that, Scenario B has a huge upside potential if the market ever does figure out that the stock is great and should be valued at a higher P/E ratio. If towards the end of the scenario, the stock in Scenario B gets re-valued with a 15 P/E ratio or 20 P/E ratio, the portfolio value would skyrocket even higher above Scenario A because the investor accumulated so many more shares via reinvested dividends while it was cheap for a long time.

This would be further amplified if the investors in both scenarios were continually adding fresh money each year. If they each kept putting money each year into more shares, the investor in Scenario B would come out even further ahead because she'd be buying twice as many shares each year for the same amount of money, in addition to her dividends accumulating more shares.

This concept applies broadly to individual stocks and index funds. Cheap stocks and cheap markets are better for accumulators, assuming the same underlying fundamentals. When stocks and stock markets are cheap, investors that put in money can buy more shares for the same amount of money, and the dividends and buybacks from those companies can buy more shares for the same amount of money.

Of course, a hypothetical Scenario C where the investor buys the stock right after it crashes would be the best of all, but everyone knows that. In practice, most people miss their chance when it comes.

Disclosure: I am/we are long LAZ, DFS, TXN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.