Key Points

  • Value investing has underperformed relative to growth investing over the last 13.3 years. The authors examine several popular narratives to explain this relative underperformance, including technological revolution, crowded trade, low interest rates, growth of private markets, and traditional measures of value that ignore internally generated intangible assets. These narratives purport to explain why “this time may be different” and why value’s poor relative performance may be the “new normal.”
  • The authors demonstrate that the primary driver of value’s underperformance post-2007 was growth stocks getting more expensive relative to value stocks.
  • The authors explore whether book value is the right denominator for value. In today’s economy, intangible investments play a crucial role yet are ignored in book value calculations. They show that a measure of value calculated with capitalized intangibles outperforms the traditional price-to-book measure, particularly post-1990.
  • With today’s value vs. growth valuation gap at an extreme (the 100th percentile of historical relative valuations), the stage is set for potentially historic outperformance of value relative to growth over the coming decade.

Executive Summary

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The Fama–French value factor, and value investing in general, has suffered an extraordinarily long 13.3 years of underperformance relative to the growth investing style. The current drawdown has been by far the longest as well as the largest since July 1963. Arnott, Harvey, Kalesnik, and Linnainmaa examine the potential causes of value’s underperformance and provide estimates of value’s performance relative to growth’s performance under different revaluation scenarios over the next decade.

Five stories may play a role in explaining value’s recent underperformance: 1) the value investing style, or factor, could be a product of data mining; 2) structural changes in the market could have caused the value factor to become irrelevant; 3) the value trade could have become crowded; 4) the value factor is becoming cheaper; and 5) a “left-tail” outlier, or simple bad luck.

Because value investing has a long history of strong performance (easily traced back at least to the 1930s by proponents such as Graham and Dodd) and solid economic footing, the authors believe the first story is an unlikely contributor to value’s recent travails. They turn their attention to the other potential stories after they first review value’s historical performance record in comparison to its record over the last decade.

Value’s Historical vs. Recent Performance

The value factor is one of the most studied and academically recognized return premiums. In their historical analysis from July 1963 to March 2020, the authors define the value factor following the Fama–French (1992) definition of high-minus-low (HML) book-to-price (B/P). This method takes the difference between two portfolios, the highest 30% and the lowest 30% of the market by B/P, which are market-capitalization weighted.

Over the period studied, value is one of the most attractive factors in terms of market-adjusted return when compared to the other factors of size, operating profitability, investment, momentum, and low beta. Even with the handful of large drawdowns over the 57-year sample period that coincided with the Nifty Fifty, Iran oil crisis, tech bubble, global financial crisis, and now the COVID-19 pandemic, a value investor is still 4.8 times as wealthy as a growth investor.

The authors evaluate seven popular narratives that propose to explain a “new normal” for value investing and for why “this time is different.” These narratives are crowded trade, technological revolution, low interest rates, growth of private markets, less migration of value stocks to neutral and growth classifications, internally generated intangibles that are not captured in book value, and value becoming drastically cheaper relative to growth. The authors state that most, excepting the last two, are only weakly supported if at all.

The narratives just described offer various mechanisms to explain value’s recent underperformance. The implications of each story can be best understood by disaggregating the three components of value versus growth: revaluation, migration, and profitability.

Revaluation is the relative valuation difference of growth versus value. Explicitly, if growth stocks become more expensive versus value stocks, the process of value stocks’ becoming relatively cheaper means value will underperform growth.

Migration in this case is when a value stock becomes more expensive (trades at a higher price-to-book, P/B, ratio) and is reclassified into either the growth or the neutral portfolio, or vice versa as when a growth or neutral stock becomes cheaper and moves into the value portfolio.

Profitability has been shown to explain the differences in the valuations of value stocks and growth stocks (Cohen, Polk, and Vuolteenaho, 2003). About half of the information contained in the P/B differences between value and growth stocks can be attributed to the differences in their future profitability, and the persistence in growth stocks’ valuations reflects their expected (15-year) profitability.

The authors find that about 70% of value’s volatility over the last 13.3 years is explained by revaluation and that over 100% of value’s underperformance relative to growth appears to be due to falling relative valuations. Hence, they conclude that revaluation is the key to understanding why growth stocks have outperformed value stocks.

Alternative Drivers of Value’s Performance

Arnott, Harvey, Kalesnik, and Linnainmaa introduce a regression-based model that accounts for the correlations of the three components of the value premium in order to examine what may have changed in 2007 and thus impacted the relative valuation of value compared to growth. The model incorporates an accounting identity decomposition that fully attributes the changes in relative valuations, between the start and end dates of the data sample, to portfolio returns.

The analysis uses two profitability measures—return on equity and earnings yield—and eight value strategies.