This is a summary of “Reports of Value’s Death May Be Greatly Exaggerated,” by Robert D. Arnott, Campbell R. Harvey, Vitali Kalesnik, and Juhani T. Linnainmaa, published in the First Quarter 2021 issue of the Financial Analysts Journal.
Flaws in the definition of value (particularly the inclusion of intangibles) are one reason for the value style’s underperformance. Preference for growth stocks is not sustainable in the long term.
What’s the Investment Issue?
Investors allocating to value stocks in 2007 and selling in mid-2020 would have nursed losses of 55%. Unsurprisingly, in light of this long period of poor performance, many investors are re-examining their exposure to the value factor.
They might, however, want to pause before they give up on value altogether. Value as a recognized investment factor has been around since the 1930s, and from 1963 to mid-2007, value beat growth by 6% a year. This long, positive track record suggests that the factor is structurally sound—and not the result of selective backtesting.
This article examines the three most plausible explanations for the large drawdown over the last 13 years. First, the 1992 Fama–French price-to-book definition of value is flawed because it fails to account for intangibles. The authors believe this definition misclassifies too many stocks as growth rather than value, ignoring the fact that many modern companies have a large investment in intangible assets. Second, investors have driven up the prices of growth stocks at the expense of value stocks. Third, the phenomenon might be a left-tail event.
How Do the Authors Tackle the Issue?
Many growth stocks would be classified as neutral or value stocks if intangibles were capitalized, thus increasing book value. The authors capitalized intangibles to see if and by how much this approach would improve returns from value stocks. Rather than treating R&D spending as an expense, they capitalized it as knowledge capital. They also capitalized and amortized 30% of selling, general, and administrative (SG&A) spending, thus treating SG&A as an enhancer of a company’s human capital, brand, and distribution network.
Next, the authors explored why value stocks, relative to growth stocks, have become cheaper than at any time in history. They decomposed the relative returns, breaking down the relative performance into three components: migration, income yield, and change in relative valuation.
Revaluation is the change in the relative valuation of growth versus value. Migration occurs when value stocks appreciate and no longer fit the criteria for value, as well as when the price of growth stocks declines and they no longer qualify for a growth portfolio. Income yield is the third driver of relative performance, because most growth stocks have faster sales and profit growth than value stocks.
What Are the Findings?
The authors find that value’s underperformance can be attributed to two main sources: Fama and French’s price-to-book definition of value, which does not include intangibles, and investors’ preference for value stocks over growth stocks.
Specifically, if intangibles were capitalized, the average return of the value factor would have been 2.2% a year higher over the last 13½ years. Furthermore, incorporating intangibles reduces the duration of the drawdown in the value factor by nearly three-quarters, from 13½ years to just 3½ years.
These findings suggest that the relative valuation of value and growth stocks is the key missing ingredient. And indeed, revaluation accounts for about two-thirds of value returns over the past 13½ years—and more than 100% of the shortfall. Much of this revaluation can be attributed to six stocks—Facebook, Amazon, Netflix, Google, Apple, and Microsoft—that have collectively risen more than tenfold since 2007. None of these stocks is classified as value.
The authors discover little evidence of any meaningful change in performance resulting from either migration or income yield.
The authors also consider that the relative revaluation is a left-tail event. Although their base case is for a return to the mean—whereby value stocks rapidly close the gap with growth stocks—the revaluation could continue and become more extreme still.
What Are the Implications for Investors and Investment Managers?
Value is not dead. By using a ratio that capitalizes intangibles, investors can substantially outperform the traditional Fama–French measure of value, beating it by nearly a twofold margin after 1990.
Given the tendency for assets to revert to the mean, expected future returns for value should beat historical performance by some distance. Even if relative valuations remain extreme, the structural components of value (migration and income yield) should provide a positive overall return to investors, which the authors estimate to be in the region of 4.5% a year.