Thomas J. Mudge III, CFA, Director, Equity Research Investment, introduces his research related to busting six value stock investing myths. Here we dive into what creates skepticism around value stocks, and the one myth that can’t be solved.
September 30, 2021
MythBusters was a long running television show on the Discovery Channel where the plausibility of commonly held wisdom or beliefs were scrutinized to determine their validity using scientific tests and experiments. Some of the myths tested on the program were confirmed as true. Apparently you can dip your wet hand into molten lead briefly and remove it unscathed (due to the Leidenfrost effect). Other myths were viewed as plausible. If you drive a convertible car with the top down fast enough in a rainstorm, (+90 mph) you may not get wet (just imperil the safety of yourself and others). Of course, many of the myths tested turned out to be false and were busted. A goldfish’s memory actually lasts for months at a minimum, not three seconds as is widely believed. The world of finance has its share of myths as well, and many center around value stocks and value stock investing.
As long-time value investors, we see a healthy amount of skepticism. If you Google “death of value investing,” you get over 60 million hits; if you then try “death of growth investing,” there’s only about half as many (35 million).
Growth Stocks are Easy to Like
Growth stocks are like symmetrical faces or the golden ratio in art, people seem instinctively predisposed to like them. The narratives attached to growth stocks primarily emphasize the positive, with words and phrases like game changer, revolutionary, cutting edge, scalable, disruptive, next generation, and category killer. Growth companies are on average more profitable, less cyclical, and of course faster growing than value companies, and their path toward further prosperity appears clear.
In contrast, value stocks typically have one or more visible and sometimes scary problems in addition to their generally slower growth and lower profitability. Value companies often reside in less exciting and old-fashioned industries like commercial printing, food processing, healthcare facilities, and footwear. Their road to future success is often unclear or difficult to imagine. It is frequently difficult to get excited about value stocks. Perversely, it is precisely this lack of investor excitement that has made value investing lucrative historically.
Two Camps of Skeptics
The source of most value stock myths come from two different but closely related camps. The “never value” group is philosophically and/or temperamentally opposed to value investing. Another set of myths comes from the “maybe value, but not right now” camp. This group sees merit in value investing, but can usually find a reason why the timing just isn’t right.
In the minds of both groups, growth stock outperformance is the natural order of things, occasionally interrupted by abnormal or extraordinary events, but destined to resume its inevitable triumph over value in short order.
To be fair, for much of the past decade—but particularly the period of 2017 through the first three quarters of 2020—growth stocks have been the place to be. Growth stocks handily outperformed value stocks during this stretch, and the initial stages of the pandemic exacerbated the relative performance gap. As students of behavioral finance, we realize the power recent experience has on investor preferences, and it is understandable growth would be particularly popular after all that success.
The prevailing order shifted dramatically when value began massively outperforming from October of 2020 through March of 2021. But, since then, value has given back much of those relative gains and still has a long way to go to even the score.
Can value stocks return to past levels of relative success?
We believe that value stocks can, and will, catch up. In our forthcoming, full-length research piece titled, “Busting Value Stock Myths”, we examine six of the many myths regarding value stocks that resurface time and again (see Exhibit 1).
As a prelude, let’s take a moment to evaluate the one myth that is neither busted nor confirmed in Bailard’s research, as it reveals much about investors’ behavior.
This time, it’s different.
It is impossible to prove or disprove the myth that the world has changed, and that conditions are different this time. The world is always changing, though the pace of change certainly varies over time. Innovation and disruption may produce a coming golden age for growth companies, or competition, regulation, intellectual property theft, another Carrington Event (geomagnetic storm), or even plain old reversion to the mean could produce just the opposite. No one knows, but given the current relative valuation starting point between growth stocks and value stocks, “this time is different” appears to be already priced in as suggested in Exhibit 2.
“People are disturbed not by events, but by the view they take of them.”
This quote from philosopher Epictetus memorializes that the power of expectations has been recognized since at least the time of the ancient Greeks. It is as true today as it was almost 2,000 years ago that people’s (and investors’) expectations determine how, and how strongly, they react to events. Most events in life have expectations built in, and expectations have the biggest impact when actual events deviate from them, particularly in the opposite direction.
Human nature tends to lead investors toward excessive optimism, overconfidence in their predictive abilities, and an inclination toward anchoring their predictions based upon recent past trends. Given these biases, and an uncertain future, what types of stocks are likely to be cursed with high expectations, and which are blessed by having to deliver very little in order to pleasantly surprise? Perhaps history offers some clues?
As you can see in Exhibit 3, stocks where high expectations are built in—growth stocks both large and small—have underperformed value stocks over the long run.
Kale, Quinoa, and Turnips
Value stocks for most people are an acquired taste. Value investing requires going against the conventional wisdom, and being wrong about 40% of the time. No matter how many myths about value investing are “busted,” the value premium has not been arbitraged away even though it is widely recognized for the same reason that health foods do not dominate the shelves of most grocery stores. Even when investors know that value stocks are good for them, many would prefer to not consume any more than necessary. Value investors have historically been compensated with higher returns for exposing their portfolios to the greater discomfort and uncertainty associated with value stocks, but that is a price that not everyone is willing to pay.
We can also argue that growth and value are both somewhat artificial constructs. By definition, even a growth manager is seeking undervalued companies within their universe. No matter what space you’re investing in, having a perception that differs from the broad market is the only way to win. Most importantly, this debate emphasizes the critical role that active management plays for growth and value investing alike. Testing the validity of theories and rumors to bust the myth and expose the truth is not only entertaining and insightful, but can aid in the effort to actively manage portfolios, their risk, and ultimately their performance.