Waiting for value stocks to end their lagging performance versus glitzy growth has become as exhausting and surreal as waiting for Godot. From 2007 through the summer of 2020, value stocks suffered through what Research Affiliates’ Rob Arnott and Cam Harvey describe as an “extraordinary span of underperformance,” where the performance differential has been noteworthy for both its length and strength.

Value stocks did enjoy brief periods of good returns during this drought, most notably when the recovery from the Great Recession began in 2009. In recent months, there has been some evidence and much speculation markets could witness a replay of a value resurgence. The bigger question is whether it is sustainable.

Benjamin Graham and David Dodd are generally credited with formally conceiving the concept of intrinsic value investing during the Great Depression. More than a half century later in 1993, two academics, Nobel laureate Eugene Fama and Kenneth French put a scientific veneer on the concept with their three-factor model, which caught the fancy of many financial advisors.

Advisors had good reason to buy into the theory. From 1981 through 2006, value stocks outperformed growth equities by an average of 2.3% annually, despite the boom in growth-style tech stocks during the late 1990s.

Since then, however, the story has taken a decidedly different turn. From January 2007 through November 10, 2020, the Russell 1000 Growth index returned 12.24% annually while the Russell 1000 Value index returned 5.96%, for an annual differential of almost 6.3%.

This has prompted researchers to engage in serious self-examination. Fama and French themselves reportedly are undertaking research to explore whether something in the financial economy has inherently changed.

The length of the business cycle has expanded, with only four recessions in the last four decades—and the most recent downturn this year was induced by government policy, not any specific weakness in the economic environment. Many believe we are in an age of disruption, with old industries like energy and retailing experiencing fundamental change.

The pandemic has only accelerated this upheaval. For example, online retailing was taking about a 1% share annually from brick-and-mortar stores in recent years. Yet in a single quarter this year it took a 4% share, or four years’ worth of market share capture in three months. At one point this fall, the market capitalization of green energy utility NextEra surpassed that of Exxon Mobil, the world’s largest company for much of the late 20th century. 2020 has not been kind to the old economy.

Historical Extremes
All this notwithstanding, smart students of markets like J.P. Morgan and Research Affiliates believe the time for an inflection point for value is now. “This is a better time to be a value investor than at any time in my lifetime,” said Arnott, Research Affiliates’ chairman, on a November 11 webcast sponsored by !Spark Network.

In a paper published this summer, Arnott and his colleagues found that the valuation gap stood at its historical extreme—the 100th percentile of relative valuations. If value returns to its historical discount versus growth, he maintains it could outperform by 7% annually for a sustained period. “When the train leaves the station, you’re going to regret missing out,” he warned.

J.P. Morgan strategists Davide Silvestrini and Marko Kolanovic told clients on November 10 that they believed markets were “on the cusp” of a rotation into value similar to the one experienced in 2016 and 2017. But therein lies the paradox.

When President Trump was elected in 2016, there was indeed a short-lived boomlet in value stocks. Given the narrative of his campaign, which promised to re-energize mature industries in smokestack America, the market adjustment made sense.

But reinvigorating industries like coal and steel proved more difficult in reality than in theory. By 2018, growth stocks returned to the limelight. The current notion that value is poised to make a run would seem to have more support from valuation disparities than from anything in President-elect Biden’s agenda, assuming he is certified.

Serious students of financial markets prefer to look beyond politics to understand why asset classes behave differently. One lens to address the disparity arises when one decomposes the sources of equity returns, notes Chris Brightman, chief investment officer of Research Affiliates.

Essentially, stocks possess three components: the return from dividend yields, the growth in earnings per share (EPS) and the change in price-to-earnings multiples. Needless to say, growth strategies have lower, if any, dividends, and higher rates of EPS expansion.

But Brightman cites another phenomenon—rebalancing, or what is called migration—as a driver of the performance gap. Simply put, many growth companies become value stocks while fewer make the opposite journey.

On rare occasions, companies like Microsoft take a round trip: It’s gone from being a growth stock in the 1990s to a value holding from 2000 to about 2013 and then back to growth in recent years. It is far more common for companies to take a one-way trip from growth to value, as Cisco Systems did in the years following 2000.

The Standard & Poor’s growth and value indexes usually rebalance about the same number of stocks each year, Brightman says. But since growth stocks are subject to more dramatic price swings, rebalancing can be more expensive. “You tend to be buying high and selling low,” he says. “Value is the exact opposite” when it comes to the price differential associated with the migration effect.

Multiple Expansion
Multiple expansion in the growth universe, however, has been far and away the primary source of the performance disparity gap. Current valuations for high-octane equities can be viewed as completely rational when one factors in the effect of interest rates into dividend discount models.

Brightman cites the Gordon dividend discount model, the simplest, most intuitive of such models, he says. It simply takes dividends (D) and divides them by the cost of capital (K), or discount rate, minus a company’s growth rate (G), or D/K-G.

Viewed through the lens of today’s negative real interest rates, it provides a mathematical justification for the greater fool theory. “When the discount rate is lower than the growth rate, the stock price theoretically has infinite value,” he says. The flip side is that these conditions make it virtually incoherent to try to calculate the real value of a growth stock. Add to this mix the behavioral impact of a pandemic, both financially and societally, and pricey, work-from-home stocks suddenly are seen as defensive plays in a winner-take-all world.

Multiple expansion may be the most obvious explanation for the sustained underperformance of value, but it’s not the only one. Markets reflect a changing set of metrics.

In their August paper, Arnott and his colleagues note that as far back as 1934 Graham and Dodd “cautioned” against overreliance on book value-to-price as a substitute for intrinsic value. In an interview in the August 2017 issue of Financial Advisor, GMO founder Jeremy Grantham said book value, the stated value of assets and liabilities on a company’s balance sheet, has morphed into a measure of which companies have the “dopiest” assets.

Companies’ intangible assets, including patents, software, brand and human capital, among others, are often at the core of a company’s “ability to generate and maintain profits,” and are often totally ignored by their book value. The Research Affiliates authors devise several ways to address the mismeasurement of value, including the capitalization of increasingly important intangible assets, but conclude it is inferior to simpler, traditional yardsticks like sales-to-price and earnings-to-price.

In the end, the authors conclude there is no definitive reason to assume that value investing is structurally impaired, even if certain companies and industries are facing secular challenges. If mean reversion is not just a concept but a law of finance, future relative returns for value should be attainable.

Exactly how that mean reversion unfolds remains to be determined. Does anyone recall the event that triggered the puncturing of the dot-com bubble?

There wasn’t one. Tech stocks like Cisco simply ran out of suckers to buy them. Wile E. Coyote managed to momentarily stay airborne after jumping over a valley. But at some point he looked down and noticed there was no ground under him anymore.

It’s quite possible that the growth-value performance gap could narrow thanks to a swoon in growth stocks, not from any surge in value.