Peanuts and Value Nobody wants to end up like Charlie Brown, flat on his back and staring at the sky while Lucy holds up the football he just tried to kick. His pathetic belief that this time will be different only makes the denouement all the more embarrassing. For this reason, I am very, very reluctant to call an end to the great decline in the value style of investing that started more than a decade ago. But on balance it really does look as though the moment has arrived. That doesn't mean that you should rush out to put everything you have into value stocks. Still, the case for increasing exposure does look strong. Before moving on, let's be clear that "value" investing has come to have two broad definitions, both of which we might associate with pairs of academics. "Graham and Dodd" value investing involves a bottom-up search for companies whose stock is so cheap compared to fundamentals that you won't lose money even if the worst happens. It was coined in the early 1930s by Benjamin Graham and David Dodd. "Fama and French" value is a systematic top-down search. Over time this "value factor" will outperform; it was documented in the 1970s by Eugene Fama and Kenneth French. This is the classic way to show how well the factor worked over the long term, in a graphic from Eugene Barbaneagra of SEI Investments Co., using Fama and French data:  The two concepts often overlap. And both have had an awful time over the last decade. The more famous active value managers, like Warren Buffett, have had difficulties, while funds based on the value factor have done terribly. After the decades of outperformance chronicled by Fama and French, the value factor has by most measures lagged behind the growth factor (choosing stocks with the strongest earnings increases) since the last financial crisis began to take shape in 2007. Banks were on many value screens before their disastrous showing in 2008, ensuring bad value performance. But in the last few weeks it has been taken to extremes. On May 15, the Russell 1000 Growth index of U.S. large-caps moved to its greatest ever outperformance of the equivalent value index, narrowly beating the previous record from early 2000 when the dotcom bubble was about to pop. Since then it has underperformed value by some 5 percentage points:  The global picture is slightly different. Growth never got so far out of control in 2000 on a global basis, and it hasn't outstripped value by as much as in the U.S. alone — but total outperformance far surpasses the previous record from 2000, according to MSCI indices:  These are remarkable numbers and suggest growth has reached a point that investors recognize to be infeasible. The top came on May 15, a Friday. This is what the Russell 3000 growth and value indices have done since then:  Are there any other reasons to believe that this is a true turning point? Banks have been the market's Achilles' heel this year. They were savagely marked down on the assumption that they would be hurt by loan write-offs as the second-order effects of the Covid lockdown made themselves felt. They are value stocks. Meanwhile, the FANG internet stocks, obviously part of the growth style, have run riot. This is how the NYSE Fang+ index has performed compared to the KBW Banks index, which covers the largest commercial lenders in the U.S.:  Caveats are necessary. There have been false dawns before. Some bad economic data or the dreaded second wave of the coronavirus would do for the banks. But this trend was already beginning to defy logic. In a world where banks would suffer so much, was it credible that the FANGs would grow enough to justify their share prices? Dominant and monopolistic though they might be, there would be less money for them to make in a depression in which banks were sustaining losses. And, crucially, if we want to confirm that value is turning the corner, a recovery of the banks relative to the FANGs is a necessary condition. That is happening. There are more reasons to believe that this time Charlie really does get to kick the football. Joseph Mezrich, quantitative strategist at Instinet LLC, points to relative valuations. Value stocks are cheaper than growth stocks by definition. But the dispersion in valuations among the Russell 1000 stocks has now grown extreme. If we use price-to-book multiples, the gap between the cheapest and most expensive has touched even greater heights than during the dotcom boom:  In absolute terms, the most expensive stocks continue to get even more expensive on this measure, though they still haven't reached the absurdities of early 2000:  What has changed with the coronacrash, which does suggest that something new is afoot, is the cheapness of cheap stocks. During the post-crisis decade, they carried on horizontally, at much the same cheapness compared to book value. The coronavirus brought their valuations to a low not seen (outside the worst months after the Lehman debacle) since the end of the bear market of the early 1980s. This chart gives value investors real reason to believe their time has come:  Various other reasons have been offered for the domination of growth over the last decade. The most popular are: that tangible assets and book value matter far less than they did; that a handful of large growth companies have established unprecedented dominance; and that specific industry bets have swamped any value effects. In other words, to an unprecedented extent, it was necessary to be long in technology, where companies are disrupting and displacing many others. For detailed refutations of these ideas, I recommend two great papers by two of the most influential figures in quantitative finance, both of whom remain wedded to the value approach. Cliff Asness, founder of AQR Capital Management LLC, recently authored a long note called Is (Systematic) Value Investing Dead? In case anyone was worried, the first words are: "No it's not." Meanwhile Rob Arnott, founder of Research Affiliates LLC, penned Reports of Value Investing's Death May Be Greatly Exaggerated, which can be downloaded in full here. These must-read papers come up with strong quantitative arguments that the dominance of the FANGs and the other factors aren't as new or as pivotal to value's fortunes as many have assumed. We still need a convincing explanation for why value would do so badly this year, and why we should expect it to recover now. Perhaps the best explanation lies in behavioral psychology. The value anomaly is rooted in human behavior, and our tendency to exaggerate and overshoot. Barbaneagra of SEI suggests that value was one of many victims of the panic that attended the onset of the pandemic. "Just as fear drove consumers to stockpile certain goods like toilet paper and flour, stripping the supermarket shelves bare," he says, "we have seen investors rapidly run from risk and toward the comfort of securities that have outperformed over the last year—overextrapolating— causing cheaper names with lower price-to-earnings to lag." Value stocks tend to look as though they have something wrong with them and hence to appear risky. This chart breaks down the reasons for value's bad performance over the quarter and the year to the end of April:  Anything that looked well run or safe performed strongly compared to the norm. Value stocks, which generally don't have those characteristics, did terribly. If we have reached the point where fear is receding, we should expect to see value do well again. A resurgence of value implies an optimistic outlook for the economy. If growth returns, then cheap value stocks won't look so risky (because even their boats have been raised). Value tends to do well at the beginning of a recovery — although note that the last great period of value outperformance, in the early '00s, came amid the onset of a recession and a bear market. As value stocks still include a lot of banks, a strong period for value also implies a steepening yield curve. This could be a dangerous bet to make when the Federal Reserve is discussing deliberately controlling the yield curve. And a second viral wave could change everything. For now, the recovery of value would help to confirm that investor confidence, justified or otherwise, is really back. There are many reasons to doubt that optimistic scenario. But the mere fact that advocating for value makes me feel like I might turn into Charlie Brown is perhaps the strongest reason for believing there is an opportunity here. One behavioral investor once told me that he adopted a "sharp intake of breath" test for potential investments. If a name provoked that reaction, the chances were that sentiment had moved too far and it was now too cheap. It is at this point that value investors can make a killing. Put differently, to quote Oaktree Capital Group's Howard Marks from an interview with me earlier this month, "every great investment begins in discomfort." Precisely because it feels so uncomfortable, it is time to start moving back into value. Survival Tips It is time to plug a great series of small books that I have just discovered. The 33 1/3 series is a collection in which each edition is devoted to an intense critical evaluation and discussion of one album. There are 142 to date. Reading one about an album you like a lot is akin to bingeing on hot-fudge sundaes. Or it is for me, anyway.
I am currently enjoying the latest in the series, on David Bowie's Diamond Dogs by Glenn Hendler. Originally intended as an operatic treatment of George Orwell's 1984, it's a daring album often regarded as a bit of a mess, much as Bowie himself was in a mess at the time. It has been great to read how it makes a coherent whole. Look through the list and you'll probably find at least something you want to read.
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