Is Value Investing Dead?

Value investing and its followers have struggled over the past two decades. That might be an understatement. The drought has lasted so long that some have understandably thrown in the towel.

Berating value investing simply because it has performed poorly is a trite and trivial argument. Different styles come in and out of favor over time, and many theoretically sound investment strategies can underperform for years by no fault of their own. Plenty of good ideas have run into bad environments.

That said, the basic idea behind value investing has flaws, irrespective of past performance.

No One Knows

Value investing is built around a basic idea: Investors should buy stocks at a price below the value of their underlying businesses. The gap between a stock’s price and the business’s true value is the edge. In theory, the market should eventually recognize the discount and increase the stock’s price to the investor’s advantage. Effectively, value investors are hunting for mispriced stocks that are trading at bargain prices.

The framework makes sense, but it suffers from a fundamental flaw: There isn’t a way to objectively know what a business is worth. Active managers that make such comparisons are really judging a stock’s price against what they believe it is worth. It’s an estimate at best.

Believe is the operative word because no one can know with certainty what the future holds. Many pieces of information have to be estimated with reasonable accuracy in order to arrive at an accurate assessment, including the business’s future value, its periodic earnings, investments in new projects and their success (or failure), and an appropriate discount rate. All those estimates compound on each other, and small errors can turn into big misses.

Assessing a business’s value is not a precise exercise. There is a degree of judgment involved, and some value investors likely consider a range of possible outcomes. But any investor engaged in this type of work has to be reasonably accurate often enough to make the effort worthwhile, and there’s a lot that can go wrong.

Arbitrage

Benjamin Graham stands apart as one of the most famous value investors of the modern era. There’s no denying his success. He even mentored Warren Buffett.

However, his edge should be placed in the correct time and place. Relatively few investors understood the advantages of investing in cheap stocks back in the 1930s and 1940s, and it was difficult. The information Graham relied on was not widely available or easily accessible. There was also operational friction. Investors had to call a broker to place a buy or sell order and pay a hefty commission to execute a trade. Graham’s edge was that he knew things that many did not.

That started to change when Graham published Security Analysis in 1934 and The Intelligent Investor in 1949. Both books explained how to find and exploit mispriced stocks. They helped more investors understand his approach. But any edge in financial markets is based on having information that others do not. So, publishing his methods theoretically ate away at Graham’s information advantage. More investors would knowingly buy cheap stocks, and enough buying could increase the share prices of cheap stocks and erode the advantage.

Subsequent research efforts further picked away at Graham’s advantage. The often-cited 1992 paper The Cross-Section of Expected Stock Returns by Eugene Fama and Ken French found that portfolios of smaller and cheaper stocks outperformed those that were larger and more expensive over long stretches. Presumably, that was the secret sauce behind the success of actively managed stock portfolios such as those managed by Graham and his disciples.

To be fair, the initial work by Fama and French didn’t account for a range of other considerations that active managers sort through, such as the underlying profits of a business. Despite that, their research still captured the basic anomaly that cheaper stocks tend to perform better than pricier stocks over the long run.

Over the coming decades, stocks trading at low price/earnings, price/book, or price/sales ratios became synonymous with value investing. Such fundamental metrics now outline the stocks held by the value indexes tracked by large ETFs like Vanguard Value ETF VTV

and iShares Core US Value ETF IUSV. Holding a diverse portfolio of cheap stocks has never been easier or more affordable.

It’s not just Graham’s books or Fama and French’s research that pulled back the curtain. Technology has helped share a lot of information that was historically difficult to compile. Price/earnings ratios along with other financial data are easily accessible today through various websites. None of it is special anymore.

If everyone knows the methods, has the information, and can transact for free, then where’s the edge?

Fear and Greed

Behavioral biases are one way that value investing potentially survives, even if the advantage is not what it once was. For example, stocks occasionally miss their earnings forecast, and their prices fall, sometimes by a dramatic and excessive amount when enough investors overreact to the news. Furthermore, the psychological pain of a loss hurts a lot more than the euphoria experienced after a gain, which begets more selling. Both can play a role in stock prices falling further than warranted after bad news emerges.

Such things still happen today, though value investing has always presented itself as the rational response to irrational prices. Disciplined and clear-eyed value investors can presumably see opportunities when others experience fear.

What seldom gets discussed are the ways that other behavioral biases can hurt value investors.

Consider what happens when a value investor estimates a stock’s worth at $70 when it’s trading for $40. The price drops to $25, which presents two possible interpretations. First, the initial thesis could have been wrong; the stock was never worth $70. The other possibility is that the stock got cheaper and the investor should hold, if not increase their investment.

That decision isn’t always clear. A lower price could be a warning about the stock. New information may have surfaced that wasn’t available or considered before. It could also be a buying opportunity.

Such decisions become more difficult when prior conviction combines with a reluctance to admit an error and realize a loss. That can cause some to hold losers far longer than the evidence warrants and wait for the market to recognize their $70 estimate, which may never come.

The problem can become more difficult to deal with because value investing requires conviction. But conviction can bleed into overconfidence. And too much confidence can cause value investors to interpret a price decline as a buying opportunity rather than a warning.

It’s Just Risk?

Set aside all the above. There’s another, perhaps bigger, fundamental problem. Value investing’s historical outperformance may not be alpha.

A simple way to look at value’s historical success is that cheap stocks are cheap for a reason: They have a lot of problems. Some are profitable, but those profits are inconsistent, or they grow at a slower rate than stocks with higher price tags. Other stocks are more leveraged, or some may be facing a substantial decline in their business.

In other words, a lot of cheap stocks are also riskier stocks. They usually perform poorly in recessions and credit contractions, and that’s precisely when losses are most painful, and investors are least likely to tolerate them. The exhibit below shows the growth of Vanguard Value ETF relative to Vanguard Total Stock Market ETF VTI

. A downward sloping line indicates the former underperformed the latter, and those periods include major economic downturns in 2007 through 2008 and early 2020.

Value Falters

Other forms of value investing, whether actively managed or passively tracking an index, try to get around the additional risk by intentionally targeting less risky stocks. Examples include Schwab Dividend ETF SCHD and Vanguard High Dividend Yield ETF VYM. Both put more emphasis on cheaper stocks that are usually less risky than a broad value index, but they come with a tradeoff: They’re not really adding alpha—instead, they’re taking on less risk in exchange for a little less reward. They should still perform better than the market when the value factor pays off, but usually not as well as Vanguard Value ETF or iShares Core US Value ETF.

From that perspective, the outperformance of value-oriented strategies and managers isn’t evidence of skill. It’s compensation for bearing additional risk. The investors who could tolerate the volatility, hold through the drawdowns, and avoid panic selling into crises got paid for doing so. Patience and risk tolerance aren’t trivial. They have real value, but they aren’t alpha.

What Survives

None of this means price is irrelevant, or that paying attention to valuation is foolish. Value investing revolves around an important idea that the price paid for an investment matters enormously to an investor’s eventual return. That’s undeniable.

The problems lie in the various approaches and beliefs built around the intuition that mispriced stocks are readily available and exploitable, and that a disciplined investor can reliably capture the gap between the two. Maybe that’s possible, but it’s arguably a lot more difficult today than in the past.

The temperament that defines value investors is something worth hanging on to. Patience, discipline, healthy skepticism, and an awareness of price are useful, regardless of how you invest. Every investor expects the value of their investment to increase over time. The late Charlie Munger summed it up best: All good investing is value investing.