Hanging on to (Small) Value

As the great Yogi Berra once said, “In theory, there is no difference between theory and practice. In practice there is”

In theory, value investing is easy. In practice, it isn’t. The idea of earning ‘value premium’ by buying cheap companies whose price sits below their intrinsic value is a very appealing one. With the proliferation of factor investing, many people jumped on the bandwagon without truly understanding what they are getting into.

As it turns out – value investing is very hard. Over the last decade or so, the good old value premium has been in hiding. Therefore, many are now tempted to abandon the strategy altogether.

Has value investing stopped working? Is the value premium dead?

These are the questions we’ve been asked a lot lately. Even the paid up members of the Church of Dimensional (a secret society of evidence-based advisers) are asking these questions. Evidence-based investors are seemingly losing faith in the evidence.

No Pain, No Premium

An important point that is often forgotten about the value factor is that it often undergoes a very prolonged period of under performance. This is why they are called ‘risk factors’.

If you just earned additional returns for factor exposures, then it’d be called a ‘free lunch.’

The chart below shows the 10- year cumulative rolling return for the value and size factors in the US, UK and global markets.

We have the longest records of Large Value, Small Value and Small Cap in the US, between Jan 1929 and March 2020.

As we can see for the US market, all the factors undergo prolonged periods of under-performance.

For example, nearly all the 10 year periods ending between March 1939 and March 1941 saw Large Value and Small Value delivering negative premium. This is repeated in 10 year periods ending between 1953 and 1956, 1990 through to 1999 and finally, the latest bout of underperformance for most 10-year period since 2014. We see similar trend repeated for UK and Global markets, albeit with shorter data series.

The chart below shows that around 20% of 10-year periods end up with a negative excess return for most of the factors.

The most prominent observation here, is the cyclical and lumpy nature of the value premium. The excess returns associated with value and indeed size factors, comes at a price – protracted periods of under-performance, relative to the overall market. There’s no free lunch here. No pain, no premium.

Ouch, ouch, ouch! Make it stop.

But, what if value premium is really dead for good? How would we even know? 

There is a raging debate in academic finance about this. I’ll point your attention to a few of them: 

1.  The Grandpas of Factors Weigh In

Last year, Gene Fama and Ken French attempted to answer the question of how long we might expect to go without value premium and wether the recent decade long underperformance is a reason to abandon factors. This is what they concluded:

Negative equity premiums and negative premiums of value and small stock returns relative to Market are commonplace for three- to five-year periods, and they are far from rare for ten-year periods. Moreover, there is nothing special about the three US equity portfolios we examine. We find similar results, for example, for a value-weight portfolio of developed market stocks outside the US. Our general message is universal; because of the high volatility of stock returns, investors cannot draw strong inferences about expected returns from three, five, or even ten years of realized returns. Those who act on such noisy evidence should reconsider their approach.

In other words, the longer our time horizon, the more likely it is that value premium will show up. That said, there is still a non-trivial chance that it may not show up even over 10 year periods. 

2. AQR: Is (systematic) value investing dead?

This paper by the team at AQR looks at some of the major reasons being given for why value investing might no longer work. One of those, is that value premium is losing its shine because everybody is doing it. 

Despite the extensive prior research supporting value strategies (across asset classes, across time periods, and across geographies), the recent underperformance of value in the equity class has led some to question whether systematic value strategies are now broken. We assess many of these criticisms, ranging from (i) increased share repurchase activity, (ii) the changing nature of firm activities, the rise of ‘intangibles’ and the impact of conservative accounting systems, (iii) the changing nature of monetary policy and the potential impact of lower interest rates, and (iv) value measures are too simple to work. Across each criticism we find little empirical evidence to support them

In other words, the apparent death of value investing is greatly exaggerated.

Diversification and Mean Reversion: Sorry, Not Sorry

This leads us to the role of diversification, not just across asset classes but also factors, particularly for the equity allocation in a portfolio. You don’t want to bet your entire portfolio on Value, Size or indeed any single factor.

For instance, regardless of its exposure to small value factor, the Betafolio Classic portfolio range has fared very well when compared to Vanguard LifeStrategy, and some of the most popular multi-asset ranges by the apparent “Masters of the Universe”.

The joke around here is, if our portfolios are holding their own when small value has been rather poor, imagine how well we’ll do when small value actually comes back?

The fact that value has under-performed during the last bull market is actually great news, at least for a diversified investor. As Dr Daniel Crosby noted, ‘Value and momentum work, independently and in concert, precisely because they exhibit the three hallmarks of an investable factor: empirical evidence, theoretical soundness and a behavioral foundation.’ In this regard, we can think of the broad market as having an implicit momentum factor, and therefore, there is a lot to be said for blending that with a value factor.

When you consider the mean reversion characteristics of asset classes, we think that this is the worst possible time to abandon small value strategy within a diversified portfolio. We would even go as far as suggesting that, if ever there is a great time to introduce small value into your portfolio, it may be now. The purpose of this isn’t to time factors – that would be incredibly silly, but as a permanent, long term exposure in the portfolio.

The hallmark of diversification is that you’re always going to apologise for the part of your portfolio that is under-performing.

If everything in your portfolio is always doing well or moving in lock step, you’re probably not well diversified. Right now, we are apologising for small value, and when small value comes back to its own, we’ll be apologising for the another part of the portfolio. This, dear reader, is diversification.

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