By Marcin Jendrzejczak with Katarzyna Plewa
The New Year 2022 is an opportunity to think more deeply and make resolutions. This also applies to investment decisions. In this context, it is worth refreshing one’s value investing philosophy and considering whether it will regain its former luster in 2022 after it fell out of favor in recent years.
Value investing is a classic investment strategy, along with its counterpart, growth investing. It consists of buying companies that are trading at a lower price than their actual value. The classic example is buying at a price below book value. In this case you are talking about buying a dollar for cents: the share represents a portion of the ownership of a particular company – its factories, patents and other assets, which in this case are bought at a price lower than their actual value as listed on the balance sheet.
The Psychology of Value Investing
Value investing is the investment strategy of Warren Buffett and his mentor, Benjamin Graham. Value investing requires a long-term view. Economists talk about low time preference here. The idea is that each person prefers present goods over future goods. This preference can be stronger or weaker. In the latter case, a person is capable of sacrificing some of his present income for future income under the condition of the chance of profit.
A value investor cannot be afraid to act against the crowd, as he follows the principle, “Buy when there is blood in the streets.” Sir John Templeton called this the principle of maximum pessimism. He encouraged buying stocks only when the market had come to the complete conviction of the total hopelessness involved.
Value stocks don’t always go up right away. As Benjamin Graham (NYSE:GHM) said, the market is a voting machine in the short term, but a weighing machine in the long term. Therefore, in the short run, stocks can fall even further. At the end of the day, however, stock prices and valuations should align.
Value investing’s long-term advantage
Value companies tend to win in the long term and also in the really long term. Since 1926, according to Bank of America, value investments have returned 1,344,600%. Over the same time period, growth investments have returned yields of “only” 626,600%.
As noted by Craig L. Israelsen in an article summarizing the research and published on the Financial Planning website, over a 25-year period (1990-2014) the cumulative annual growth of the S&P 500 index was 9.62% and the standard deviation was 18.25%. This means that investing $10,000 grew to $99,350 after 25 years (the real return was lower due to inflation). In the case of large U.S. companies, value investing yielded a premium of 86 basis points. For medium-sized companies, the premium was 99 basis points. For small companies it was as high as 224 basis points.
Moreover, the author examined the situation in 21 periods of 5 years within the examined time range. Among the category of large companies, the value ones “won” in 52% of cases. Among small companies, value turned out to be the winner in 76% of 5-year periods (although in the period 1995-1999 when growth companies won, their advantage amounted to as much as 860 basis points).
Two principles therefore emerge from the research. First – the longer the periods, the higher the chance of value investing advantage. Second, the smaller the companies we take into account, the higher the advantage.
The last decade – an exception, or the new rule?
However, this has become less obvious. Recently, growth investing has surpassed value investing. Over the past decade, for example, the iShares Russell 1000 Growth index (NYSE:IWF) has returned 17% annually, while the iShares Russell 1000 Value Index (NYSE:IWD) has returned just 10%. Some analysts see this as a fundamental shift in the markets caused by technology companies. Others recall that the same argument was made just before the dotcom bubble burst in 2000.
So has the world changed? As proponents of the so-called new economics point out, today it is no longer physical capital that matters, but rather human capital. Consequently, traditional ratios such as price/profit or price/book value are becoming obsolete. An IT company may not have a lot of capital at its disposal, but it can still be a great business. This is because its capital is in people’s minds. “Asset-light” is a positive for modern businesses, not a drawback.
So let’s take a closer look at the case. Our “backtest” on the Portfolio Visualizer portal covering the period 2011-21 showed that a $10,000 investment in an ETF representing large (from the SP500 index) U.S. growth companies yielded $58,056 at the end of 2021. In contrast, an investment in the iShares S&P 500 Value ETF (NYSE:IVE) representing large U.S. value companies yielded $31,764 at the end of the period.
However, for the first half of the decade, the results were even. So the lion’s share of the difference is accounted for by the latter part of the decade, especially the period since April 2020. After all, as recently as March 30, 2020, the growth advantage was only just under $8,882, rising to $26,292 by the end of 2021.
The comparison in the small-cap category is similar – the iShares S&P Small-Cap 600 Value ETF (NYSE:IJS) versus the iShares S&P Small-Cap 600 Growth ETF (NASDAQ:IJT). The cumulative annual returns are 11.56% and 13.64%, respectively, and the $10,000 investment yielded $7,383 more at the end of the period for the small-cap growth investments. Again, the two portfolios were very aligned until 2017. Only after that did the divergence begin.
In contrast, the iShares S&P Mid-Cap 400 Growth ETF (NYSE:IJK) had an accumulated annual return of 12.49% and the $10,000 invested brought in $36,142, while the iShares S&P Mid-Cap 400 Value ETF (NYSE:IJJ) had an accumulated annual return of 11.27% and the $10,000 invested brought in $32,076 at the end of the period. In this case, the charts were very even until the end of March 2020.
The prevalence of growth companies in recent years appears to be not so much a trend change, but rather an anomaly. It has been shot through with non-standard monetary policy, such as asset purchase programs and negative real (and extremely low nominal) interest rates. The correlation with the Fed’s spring 2020 decisions is striking here. It is hard to talk about coincidence here – rather, a cause-and-effect relationship is obvious. So it is not a paradigm shift in economics, but a change in Fed policy that is chiefly responsible for the gigantic valuations of growth companies in recent years, and especially after 2020.
Thus, the Fed’s retreat from a radically dovish policy threatens a deep correction in growth companies. The higher the level of overvaluation, the greater the correction will be. Let us remember that the Fed currently anticipates ending the asset purchase program at the end of Q1 2022, followed by interest rate hikes spread over 2022 and 2023. Of course, one can imagine a situation where, in the event of an overly negative market reaction, the central bank will revert to its old policy. However, record high inflation will be a barrier difficult to overcome in recent years.
Thus, the recent strong growth of companies is in fact an additional argument for the fact that the next few years will once again belong to value companies. Similarly, overvaluation of the US market may lead to capital flow to less popular emerging markets. Value investors will find interesting companies not only on the expensive American market, but also on those located in Latin America, Russia, the Czech Republic or Poland.
The Growth Disparity: Not Only in America
It is worth remembering, however, that unrealistically high valuations of growth companies are not only a U.S. problem. As Anthony Luzio of Trustnet Magazine points out, the price/earnings ratio for the MSCI Growth index of global growth stocks is currently 37.7, which is 2.5X more than for its value counterpart. While in essence growth stocks are more expensive by definition, the difference has typically been 1.4X. It is now 2.5X. So even if we take a global perspective, we find that growth stocks are overvalued more than usual.
Of course, this is just a hypothesis. The only thing we know for sure about the future is its uncertainty. Moreover, in the shorter term, growth companies, often related to technology, can produce truly remarkable returns. Most experts also suggest diversifying your portfolio. In a diversified portfolio there is room for different types of companies, although nothing prevents one type from predominating.
Finally, it is worth remembering that even if we adopt a value investing philosophy backed by historical data, as well as common sense and big names, we should not limit ourselves to it. Low valuation is an important, but not the only, indicator determining the future success of a company. No less important turns out to be size (as a rule smaller companies give higher profit, but with higher volatility); quality (good finances of the company) and the momentum factor (what grew last year, often grows further in the next). Someone might advise that a portfolio should also include growth companies, but selected very carefully or that they should be invested in as part of ETFs. Then we do not depend on a single company, which can often transition from today’s market darling to tomorrow’s bankruptcy. Among today’s growth companies are tomorrow’s Amazons, but also many companies that will not thrive or perhaps even survive.
In a way, the ideal seems to be a small, high-quality company – with good financials, cheap, but whose share price has already started to bounce back. As we can see, there are many indications that the year 2022 will usher in a return to value investing, and the new year is a good opportunity to create an investment plan based on professional valuation and analyst opinions. As always, the key to success remains patience, sticking to common sense, avoiding greed and investing only what you can afford to lose.