Gerard O’Reilly on the Future of Value Investing
The decade-long onslaught inflicted by growth stocks on value investors is due to end, according to Gerard O’Reilly. But the data is too “noisy” for him to say when that will happen.
O’Reilly is the CIO and co-CEO of Dimensional Fund Advisors. Dimensional is the leader in factor-based or “structured” investing. It is a 40-year-old firm with 1,400 employees and 13 offices globally. It has $600 billion under management, most of which is in equities with 20% in bonds.
He was interviewed via webinar on January 21 by Alex Shahidi and Damien Bisserier, who are the managing partners and co-chief investment officers at Evoke Advisors and ARIS Consulting, a Los Angeles-based asset manager, as part of its master speaker series.
I’ll discuss O’Reilly’s predictions for value investors, but first let’s review his background and what he said about Dimensional’s strategy and positioning.
An Irish rocket scientist
O’Reilly has a PhD from Cal Tech in aeronautical science, making him a bona fide “rocket scientist.” He said that education refined his analytical skills and taught him to make cogent arguments in response to his peers. With a PhD, the goal is to find and create something new, which he said translates to Dimensional’s mission of academically vetted methodologies.
He landed at Dimensional in 2004 in an almost-accidental way. He is Irish and is not a U.S. citizen. Dimensional was recruiting at Cal Tech, and O’Reilly found the opportunity because it did not require citizenship.
O’Reilly recounted Dimensional’s history. It was founded in 1981 by David Booth and Rex Sinquefield and was based on their graduate work at the University of Chicago. Their goal was to identify investor needs that could be met in a scientific way, starting with small caps.
It launched a small-cap strategy, and recruited Myron Scholes, Eugene Fama and Ken French, all Nobel laureates. Over the ensuing 40 years, it added fixed income, global fixed income, value, multi-factor strategies and other asset classes.
The common theme underlying Dimensional’s investing is that it views prices as predictions of the future – every trade represents information. It does not try to outguess markets, but to look at what information is embedded in prices to improve prospective returns.
Like active investors, O’Reilly believes there are differences in expected returns, which may be due to disparities in information or risk preferences. But Dimensional seeks an advantage by focusing on what it can control, like turnover, diversification, and exposures to parts of the market, and tries to do that as efficiently as possible.
The alternative, he said, is to believe that some prices are wrong, and that you are smarter and faster than other investors. But that leads to portfolios that are more concentrated and riskier.
He cited the example of Tesla, which went up nearly eight-fold last year. That could have been due to increased consumer demand or favorable regulation. But Dimensional doesn’t ask if its price is too high or too low. It knows Tesla is a growth stock with lower-than-expected market return. The opposite case is an airline stock, where investors demand a higher return to own them.
“Prices are what they are,” O’Reilly said. “We try to understand what returns the market is demanding to hold them.”
He advocates diversifying across stocks, sectors and countries. A well-diversified strategy narrows the range of outcomes at both extremes, he said.
Last March when volatility spiked, O’Reilly said that bid-ask spreads increased, particularly in the fixed-income markets. But diversification gave them the flexibility to select how, when and what they bought and sold. The bond markets were liquid (twice as many bonds changed hands than in February), and Dimensional was a net seller because other investors were rebalancing out of bonds into equities. Dimensional’s execution price was 100 basis points better than others in the bond market, O’Reilly said.
“Diversification gave us the flexibility to be that seller of distressed items,” he said.
Looking backward or forward?
O’Reilly was asked whether Dimensional’s focus on prices as a source of information would cause it to miss out on exceptional opportunities, like Amazon a decade ago.
The answer, he said, lies in separating what return should be expected based on market prices, versus the performance that represents an unexpected component.
Investors will not be rewarded for relying on the unexpected. Much of Amazon’s performance over the last decade was unexpected, he said, based on the quantifiable metrics of its business at that time.
“You can’t get to that unexpected component,” O’Reilly said. Facebook and Netflix have doubled every two years but going back 10 years nobody expected them to grow at 35% a year. Expectations were 8% or 9%, and the rest of that growth was unexpected, including that due to COVID.
“The unexpected component is not rewarded but can be captured by diversifying,” O’Reilly said.
In the late 1990s and early 2000s, there were many companies vying to be among the few that would dominate the technology industry. We are now seeing the small number of winners, he said. “People shouldn’t be led to believe they can pick the future winners.”
Active managers offer no compelling evidence that they can take advantage of the Teslas or Facebooks in real-time to the benefit of investors, he said, “with some exceptions.”
Betting on those historical outperformers doesn’t work either, he said. Even though those technology firms changed the way we live, they underperformed the broader market by 1% or 2% a year after their rise to dominance.
He referenced the well-known survivorship bias in mutual funds. Returns across funds were 0.5% to 1.0% lower per year over the last 20 years, when you include all those that were liquidated or merged.
Has value been overgrazed?
After a decade of underperformance relative to growth, value investors have suffered greatly.
According to O’Reilly, all stocks do not have the same expected return, and that implies a belief in the value premium. Value stocks are those that have higher expected returns. The value premium goes away when you expect all returns are the same.
What has changed, he said, is the way you identify those value stocks. Firms like Dimensional need to adapt their approach to incorporate changes in regulations and the market microstructure. He said his firm processes data much differently from how it did 20 years ago.
The last three years were the worst ever for value stocks, he said, which followed a “tepid” seven-year period. Value returned 2% for those seven years and then did sharply worse. A lot of those losses were related to COVID and the big hit suffered in the energy and travel industries.
Now, he said, those stocks with lower prices have even higher expected returns.
Spreads, using P/E or P/B, are historically wide. But that data is quite noisy, he said, when it comes to predicting returns. “Growth is very growthy,” he said, “and value is the same.”
“Returns may be higher, but I am not going out on a limb,” O’Reilly said, because the data is too noisy.
O’Reilly was asked whether too many investors have tried to exploit the value premium and, as a result, it has been “overgrazed.”
The crowding argument is not compelling, he said.
Small caps are still attractive and have always been, he said. The same is true with momentum and profitability. But, he said, money manager data shows no change in distribution of returns, meaning those investors have shown no increased ability to exploit those asset classes.
There is no greater aggregate demand for value stocks than before. If so, he said, it would move prices up. But the value premium has been negative over the last decade, and that refutes the overgrazing argument, according to O’Reilly.
The other possibility is that the surge of assets to value took place in the prior period – in the 2000s or earlier – and that led to value’s outperformance in that period. Those assets remained invested in the 2010s, but by then stocks with the lowest P/B or P/E ratios were not as attractive as they had been, say, at the start of the 2000s. That led to poor returns. Unfortunately, there is no way to accurately measure asset flows to value strategies, and O’Reilly did not comment on that scenario.
What about U.S. or home country bias?
The reliability of outcomes (meaning the outperformance versus the broad market) goes up with the more countries you include, according to O’Reilly. Value has been negative in the U.S. he said, but it has been positive in 14 other countries. Diversification gives you the flexibility in implementation to capture those county returns, considering that you don’t know which regions or countries will outperform.
But, he said, U.S. investors can be justified in overweighting U.S. stocks for two reasons. The familiarity bias works in their favor. It can turn people into longer-term investors, which will lead to greater success. Also, dividends from foreign companies are subject to withholding, and that withholding is lost in a tax-deferred account. That reduced dividend may be an unacceptable cost to a U.S.-based investor.
Does competition threaten Dimensional?
O’Reilly credits Dimensional with becoming experts in transparency, innovation, stewardship and understanding how to work with capital markets.
“Markets will give you less than your fair share of returns for the risk that you bear,” he said. “We focus exclusively on getting our fair share of returns the capital markets will give for the risks we bear.”
O’Reilly said it’s important to be transparent to allow his firm to be monitored, to allow expectations to be set, and to be judged fairly. Dimensional, he said, has done this.
But some people have copied us, he said, and that is flattery. It does not bother him, because competition makes Dimensional better at execution and explaining what they do.
“The size of the pie has gotten bigger,” he said, because there is more demand for the strategies` Dimensional runs.