Value's Lazarus Moment

In the Bible, Jesus arrives to help his friend Lazarus a few days after he had already died. His friends Mary and Martha were very disappointed because they thought all hope was lost. As the story goes, Jesus raised Lazarus from the dead. We bring this up because of a recent blog post at The Wall Street Journal from Wesley Gray of Alpha Architect. He asked the question, “Is Value Investing Dead?” The centerpiece of the argument was the chart above, which shows a dismal ten years for value investors:¹

Since we have practiced our large cap value management discipline for nearly ten years, we thought it would be helpful to dissect and explain value investing’s difficult era and show where we fit into this discussion.

From a ten-year standpoint, the financial meltdown of 2007-2009 crushed low price-to-earnings ratio (P/E) and low price-to-book value ratio (P/B) stocks early in the period. Mathematically, value got off on the wrong foot early in the sequence and it was a deficit which could not be made up in the aftermath by low P/B stocks. In effect, value was in the tomb.

There has been a big differential in performance between measuring value by P/E versus measuring by P/B in the last ten years:¹

Economic historians will most likely look back at the anemic nature of the economic recovery since 2009 and the resulting historically low interest rates as a driver of growth stock success. First, when growth in the economy is hard to come by, investors will pay up for any definable growth, even if it is profitless.

Second, the best growth in the economy emanated from the technology sector of the S&P 500 Index, which historically trades at very high prices in relation to book value. Third, very low interest rates for a long stretch of time emboldens investors to over-pay for future growth and creates a psychological extreme. Lastly, commodity prices broke down beginning in 2011 decimating energy and basic materials company shares. These kinds of companies traditionally dominate the lowest P/B quintile and sealed the tomb.

As a firm, we have eight criteria for stock selection which lean toward the P/E side of the value equation. We aim to be a low turnover manager (approximately 16% on average over the last five years), meaning that we hold our winners a lot longer than most value managers. Historically, this has meant that we have allowed our holdings to remain in the portfolio long after leaving the lowest P/E quintile, keeping us very much alive.

We do this because of the qualitative characteristics we screen for in our eight criteria for stock selection. Effectively, the low P/E stocks we bought years ago and have held many years were more rewarding than trying to make lemonade out of each year’s low-price quintile lemons. Business hasn’t been good in the stock market graveyard.