The value premium, which is this idea that a basket of statistically cheap companies would outperform the market was thought to exist for two reasons:
- You’re being compensated for the extra risk that you’re taking.
- These companies are generally flawed businesses, but investors overdo it to the downside. Basically momentum but in reverse.
It has not delivered on either of these premises for a very long time.
Over the last ten years for example, large value compounded at 8.7%, while large growth compounded at 15%, leading to a 6.4% annualized spread in performance. The only time frame in which value has outperformed growth is the last 20 years, right as the dotcom bubble was bursting.
I was only a teenager during the dotcom bubble, so that probably disqualifies me from saying “I never thought we’d see something like that ever again.” But I’m going to say it anyway. I never thought we’d see something like that ever again. I was wrong.
The “that” which I’m specifically referring to here is not the bubble in growth stocks, but the depression in value stocks relative to the expansion in growth stocks. Value is officially as cheap as it has ever been.
I’ve always thought that the smart beta boom was a baby of the dotcom bubble. Anything that used a fundamental screen looked something like value and nothing like growth. This led to massive outperformance as value gained 14% from 2000 through the end of 2003, while growth crashed by 42% over the same time. But I digress.
The chasm today between cheap and expensive, unlike the dotcom bubble, is not just due to the gain in technology stocks, which is the common narrative these days. Nor is it due to the winner-take-tall type of market that is leading to the big stocks getting bigger. Nor is it because of archaic ratios, or differences in profitability, or differences in leverage. Once you control for all of this, cheap is just cheap. Cliff Asness took on all of these arguments and more in a new post, Is (Systematic) Value Investing Dead?. In Cliff’s words “Investors are simply paying way more than usual for the stocks they love versus the ones they hate.”
Asness attacked this question from all angles, but there’s a potentially simple explanation that he overlooked. Perhaps there is no meaningful information in the size of a company relative to its underlying fundamentals. Okay, I’ll admit this feels completely ridiculous to type, but hear me out. What I mean is that it’s possible that investors have collectively gotten so good at pricing individual securities that there is no longer inefficiencies to exploit using simple metrics. What if the price-to-earnings ratio, or any ratio for that matter, is just information without any meaning? What if the market is micro efficient?
This is not a new concept but rather a very simple one that I think is worth revisiting. Paul Samuelson said:
Modern markets show considerable micro efficiency (for the reason that the minority who spot aberrations from micro efficiency can make money from those occurrences and, in doing so, they tend to wipe out any persistent inefficiencies).
For the record, I’m not sure that I want to die on this hill, but I think it’s a fair question to ask. The other side of this is that because the market has gotten more micro efficient, these premiums are harder to exploit, and therefore require an extraordinary amount of patience and a herculean ability to withstand pain and suffering. I’m not sure I believe this either.
Now might prove to be a generational buying opportunity, given the fact that spreads have never been wider, but perhaps the days of investors throwing the baby out with the bath water are gone forever.