Introduction

The past few years have been a humbling experience for global value investors. Value investing at Mercer Private Wealth has been no different. As far back as July 2016, our Edmonton team published an article called “Keep the Faith in Value,” only to watch growth investments go on a historic run over the next four years.

We were not alone in our astonishment at growth investing’s recent incredible pace. Even investment giant Vanguard has not been spared. In July 2020, Vanguard threw in the towel on an actively managed value fund with a 20-year track record.1

 

What does this tremendous outperformance of growth relative to value mean for the future?
In this quarter’s Optimist, we review the recent performance of growth and value indices against their longerterm averages. True to our name, we find evidence to remain optimists.

Outliers

By one measure, the most recent decade was value’s worst relative performance in 90 years (Figure 1). Although this appears negative for value, this chart provides a relative comparison.

In other words, while total returns for value were positive, growth investments provided an additional positive return of 2.6% above value. However, a key question remains unspoken within this simple chart: Was this performance variance the result of value doing poorly or growth doing surprisingly well?

Figure 1. A difficult decade: Relative performance of value versus growth in the United States 2

Average annual performance of Fama and French (“HML”) value factor by decade

In answer to this question, it can be helpful to compare recent performance of value and growth against their longterm historical returns. Figure 2 below shows performance over multiple periods, including to the middle of 2020, a point at which growth was booming out of the COVID-19 downturn.

 

What does breaking performance into these periods tell us?
Not only did growth outperform value through the first seven years of the last decade, over the next three years, growth stocks went on to almost double their historical return!

 

How common is this doubling of historical return by growth?
It has literally never happened before: The three-year period in this chart (July 2017–June 2020) was the best relative three-year performance by growth in modern US stock market history.3

Figure 2. Unprecedented performance of growth4

Annualized compound returns for value versus growth, US market

Value optimism

Although the unprecedented returns from growth stocks may seem like a spectacular opportunity for investors, history teaches that we should be cautious extrapolating into the future. In fact, while it is nearly impossible to time markets accurately, valuation metrics have been effective at predicting average market returns over the subsequent 10 years.5

Unfortunately for growth stocks, however, average future returns have been inversely correlated with valuations — and right now, growth stocks are extremely expensive.

 

To illustrate, we provide two valuation metrics to compare growth companies versus value companies, as well as current valuations versus long-term averages for each.

Figure 3. Value versus growth, price-to-book, January 1995–February 20216

Figure 4. Value versus growth, price-to-earnings, January 1995–February 20217

Not only are growth stocks significantly more expensive than their value counterparts, but, perhaps more importantly, growth indices are dramatically more expensive than their long-term averages.

 

In contrast, value is not particularly expensive. As a result, the “underperformance” of value over the past few years may be more about the historically rare outperformance of growth companies.

 

Will growth stock outperformance continue?
If long-term history is an indicator, the answer is likely no. As we saw in Figure 1, growth outperformed in two previous decades (the 1930s and 1990s). The subsequent decades resulted in dramatic outperformance by value.

Is it different this time?

“When the facts change, I change my mind. What do you do, sir?”

Economic folklore attributes this quote to economist John Maynard Keynes. Although we cannot be sure whether he actually uttered these words, they are a beautifully simple expression of the profound power of evidence-based thinking.

It is particularly difficult to distill “facts” within investing and then use them to invest successfully. This is true for two reasons:

 

  1. Markets are adaptive, ever-changing mechanisms for discovering the prices of assets.
  2. Markets have historically exhibited mean reversion, resulting in performance-chasing being a key contributor to wealth erosion. 

As a result, the best investment approach for serious longterm investors has been to own the diversified strategy they can stick with even when it experiences a period of unexpected performance.

 

Unfortunately, these contradictory axioms highlight the unending challenge faced by long-term investors: When a strategy has been underperforming, how do we know if we should stick with it or adapt because markets have changed?

Investment researcher Larry Swedroe has a concise, five-step model that we find particularly useful for analyzing this conundrum8:

 

  1. Persistence: Has the strategy provided relatively reliable returns over long historical periods and different economic regimes?
  2. Pervasiveness: Does the strategy work across different geographies and asset classes?
  3. Robustness: Does the strategy work across various measurements (such as for both price-to-book and priceto- earnings)?
  4. Intuitiveness: Does the strategy have an economic reason for existing; that is, does it make sense?
  5. Investability: Can Canadian families invest in the strategy? Can the strategy be held without costs being catastrophic to returns?

The academic research supports the persistence, pervasiveness and robustness of value investing, despite value’s recent challenges. When it comes to economic intuitiveness, at its core, value investing is about paying lower prices for assets that will provide future cash flows. Paying lower prices for equivalent future cash flows provides higher investment returns. It is intuitive, therefore, that value investing should have higher expected returns.

 

In summary: When statistically strong, third-party, peerreviewed research can provide economic foundations for why valuations are no longer relevant across multiple geographies and asset classes, then value investors should change their minds. We are not there yet.

Managing emotions

Although we agree with Keynes’ focus on the importance of changing minds, there appears to be little reason to believe that recent market events have changed the “facts” about value investing. In light of this, staying invested until the value premium appears again is imperative. Managing emotions and expectations through disappointing market events, as in the past few years, is an absolute necessity. But how can we best do this?

At Mercer Private Wealth, we believe diversification is the most effective way to reduce the pain and challenges of unexpected performance. In this regard, although investing in value is a significant part of our strategy, it is not the only investment style we deploy in managing our clients’ assets. We continue to employ allocations to other market characteristics supported by Swedroe’s five-step framework, and are happy to discuss these with clients any time.

Conclusion

Humility is a key contributor to the success of long-term investing. As the future is unpredictable, realized investment returns will always come with a serving of the unexpected.

 

Although a surprise to the downside may be disappointing, these are common and should actually be expected in markets. An evidence-based decisionmaking model like the five-step model outlined in this article provides us with confidence that value investing will still have its day in the sun. Until then, staying invested in productively diverse assets remains the optimum strategy.

Cary Williams
Cary Williams
Private Wealth Counsellor
cary.williams@mercer.com

 

References

1 Benjamin J. “Vanguard Submits to Value Curse, Plans to Fold Active Fund Into an Index,” Investment News, July 29, 2020, available at https://www.investmentnews.com/vanguard-closes-value-active-fund-195618.

2 Mercer Canada Limited. Is There Still a Case for Value?, 2020, available at https://www.mercer.ca/content/dam/mercer/attachments/north-america/canada/ca-2020-is-there-still-a-case-for-value.pdf.

3 Dimensional Fund Advisors Canada ULC. “An Exceptional Value Premium,” October 5, 2020, available at https://www.dimensional.com/gb-en/insights/an-exceptional-value-premium.

4 Ibid.

5 Finke M. “The Remarkable Accuracy of CAPE as a Predictor of Returns,” Advisor Perspectives, July 20, 2020, available at https://www.advisorperspectives.com/ articles/2020/07/20/the-remarkable-accuracy-of-cape-as-a-predictor-of-returns-1.

6 MSCI World Value Index price-to-book value versus MSCI World Growth Index price-to-book value for the period starting January 1, 1995, and ending February 26, 2021. Data via Bloomberg.

7 MSCI World Value Index current price-to-index trailing 12-month earnings versus MSCI World Growth Index current price-to-index trailing 12-month earnings. Data via Bloomberg.

8 Swedroe L. “Swedroe: Examining Factor Persistence,” September 17, 2018, ETF.com, available at https://www.etf.com/sections/index-investor-corner/swedroe-examining-factor-persistence?nopaging=1.

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