Value Investing Not Dead, Just Wait

May 07, 2019

Wes GrayWesley Gray is a well-known quant in the ETF world. As co-founder and CEO of asset management firm Alpha Architect, he's shared his extensive research with investors everywhere, and applied his expertise in factor investing to five ETFs the company currently sponsors. Gray will be speaking about value investing at the upcoming Morningstar Investment Conference in Chicago this week.

ETF.com: There’s some discussion over what drives the value premium. Is value risk-based or behavior-based? And why is that an important distinction?

Wes Gray: It's probably a mix of both. But it's very hard to distinguish between one or the other. The only people who truly care about that distinction are academics. But it’s an interesting discussion. For example, think of Best Buy. Best Buy is a firm that fights Amazon. So why is it so cheap relative to Amazon? And why would we expect to earn excess returns?

 

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Clearly, there's a component of risk. They could die in their fight against Amazon. But there's another component—what if there's just really bad sentiment about the company, and people have thrown the baby out with the bathwater?

The reality is, when it comes to the source of return linked to value, there are both risk and behavior elements involved. But I'm not sure it would really change your decision. Because in the end, if you want to get the excess return, you have to own Best Buy.

ETF.com: So, for the investor, the distinction doesn't really matter.

Gray: It’s an interesting debate. Let's say it's pure risk. That’s great, because in an efficient market sense, if you can take on real fundamental risk, on average you should earn real fundamental excess returns.

But say it’s pure behavioral risk. The only way that behavioral risk “shows up” in prices is that it has to be risky to arbitrage against the “dumb” people. The simplest way to understand that is like career risk. You have to own something crazy, like Best Buy, and everyone hates you.

Whether it's pure risk and it makes the efficient market guys happy, or if it's pure behavioral, I'm not sure it really matters. You own pain and you get some gain, or you don't own pain, and you don't get gain.

ETF.com: Some say traditional value versus growth investing no longer works, and value needs to be redefined. Do you agree?

Gray: I would say the devil's always in the details. You first have to find out what people mean when they say “value” or “growth.” Everyone should just at the beginning say, “Let's all agree what is the definition of value. What’s the definition of growth?”

If we’re defining value as, traditionally, book-to-market, because that's what everyone uses, and growth as expensive book-to-market, I’d argue it still matters. Value (if you buy cheap stuff, on average, over long cycles of time) is going to outperform growth (expensive stuff) almost by definition.

Otherwise, the market's totally screwed up. Is one maybe riskier? Possibly. But lower price generally means higher expected returns versus high priced.

ETF.com: Value stocks are particularly risky, though, because you're betting on forecasts or projections of earnings that might not materialize. How do you best manage or mitigate risk in a value strategy?

Gray: There's no way to eliminate most of it. You've just got to own the pain. At the margin, the way you make sure you're not going to catch a falling knife is to focus on quality. Once you're in a cheap stock, how do you separate the good ones from the bad even though all of them are going to be risky? With quality-type metrics—good old-fashioned fundamentals.

Another basic technique people use is momentum. If you have two value stocks, one has stable momentum, and the other’s like the biggest loser stock in the whole universe, that's probably something to avoid at the margin.

ETF.com: Year-to-date, value has underperformed growth by about 5 percentage points. In the past 12 months, value underperformed by about half. Same story in the past two years. Why this persistent underperformance? And what’s it going to take for it to turn around?

Gray: It's like anything: If you buy higher risk and higher volatility, the outcomes sometimes don't end well. The problem is people always want to create their portfolio based on the last most recent performance.

It’s really like gambling. If you played blackjack, and you have a 10 showing, do you hit, or do you stay and wait? Obviously, the smart bet is to take a card. But maybe you just sit at 10 and it works. It works five times in a row.

Now, the question is, is it a good strategy to keep sitting on 10 for the next hand? The answer is no. But a lot of investors would say yes, because they extrapolate past performance as predictive of future performance. In the end, what predicts your future performance is the process.

If your goal is to earn higher expected returns than, say, the S&P 500, the process that does that on average—the smarter bet—is to load up on risk-type things, like small cap, value, etc. It's not to load up on mega cap U.S. equity. Don’t get rid of your value because it hasn't been working, but arguably get more of it—if your goal is to try and beat the S&P 500 over the next 20 years.

The reason you want to own strategies like value, even though they've had a bad three-, five-, 10-year run, is that we already know historically they’ve had three-, five-, 10-year runs, but we also know historically they’re capturing risk premia that tends to beat the market, on average.

ETF.com: The key for value investing is to be a long-term investor?

Gray: Yes. It's what I always say: If you can't handle the heat, get out of the kitchen. That's the bottom line on value. You can’t time it. It’s simply no pain, no gain.

Contact Cinthia Murphy at [email protected]

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