In our ongoing mission to broadcast the attractions of value investing around the globe, a line we are hearing with increasing frequency, here on The Value Perspective, is that the strategy tends to underperform in falling markets.
Given the largely upward trajectory of world markets over the last decade or so and the recent increase in volatility, such a concern is quite understandable – but does it actually correspond with reality?
At first glance, you might well think so – after all, during the opening stages of the financial crisis in late 2007 and into 2008, a value strategy indicated a high weighting towards banks and other financial stocks. Therefore value investors had a terrible time.
Understandably enough, that experience will still loom large in many people’s memories – and yet, over longer timeframes, it actually stands out more as an anomaly.
Indeed, you only need to look back to the most recent bouts of market stress – in February, October and December 2018 – for instances of value holding up very well as wider markets fell.
A paper from Société Générale’s Global Quantitative Research team, however, goes back a good deal further and, when you read its title, you will understand why we believe it is well worth highlighting.
The Defensive Side of Value Investing and its Potential Resurgence – oh yes – starts by acknowledging “the conventional economic narrative” that “value stocks rebound in early phases of an economic cycle, with the upsurge in prospective growth, while staying depressed through economic/market downturns”.
Yet the SocGen analysis indicates value also “tends to stay resilient and often rebounds” during most such falls.
“Value appears to perform strongly during rare ‘crisis’ events, with the lion’s share of the terminal value of the strategy historically coming from statistically few market events that proved to be positive return moves to the value strategy,” the paper observes. “The events associated with value outperformance also appear to overlap with periods of systemic blow-ups to many risk assets and strategies.”
This provides value with what the SocGen team calls “a convex pay-off structure”, which translates as “significant upsides in down markets”, and they illustrate this point by picking out 12 instances of “significant market distress” between 1990 and 2018.
As the following chart shows, the group’s Global Value benchmark outperforms the main US index, the S&P 500, each time – including over the full 2007/09 financial crisis.
SG Global Value (LS) during market stress, 1990-2018
Source: SG Cross Asset Research/Equity Quant
Past performance is not a guide to future performance and may not be repeated.
Looking back even further, the team then focuses on the value factor data assembled by US academics Eugene Fama and Kenneth French, which dates back 90 years and throws up 25 periods of market distress.
And while value’s absolute return performance is mixed, including 11 negative returns and 10 strong rallies, the SocGen team notes “the value rallies are stronger than the worst value downturns”.
And they add: “Overall, the impact of these systemic market events was significantly lower on the average performance of the value strategy compared with the impact they had on the broad market.”
One of the implications of these findings, the paper goes on to suggest, is value’s potential as hedge, offering “needed uplift when many traditional funds struggle … at least for medium to long-term investment horizons”.
“Value picks up performance, or at least stays put, on average, when broad markets undergo significant distress,” the paper continues. “What is more, value does well in bull markets, its cyclical exposure helping to boost performance, allowing investors to participate in the upside, while other traditional hedging-type strategies tend to get hamstrung in those environments.”
Before you grow too concerned either we or the SocGen team are painting an unrealistically rosy picture of value, we should add that we would not necessarily disagree with the latter’s observation that “contrarian as a strategy, value undergoes long, agonising periods of underperformance, tempting the will of the most patient investor in the process”.
However, as the SocGen team also says, value can “end up roaring back with staggering performance occasionally” and they conclude: “With the increasingly bearish mood of global markets as financial assets undergoing massive repricing at the tail end of the longest bull market, combined with the historically low current valuation of the value strategy, conditions appear to be conducive for the long-awaited value rally.”
As for our own conclusion, well, the defensive qualities of value have long been apparent to us, here on The Value Perspective.
As we put it in the context of UK banks in Three quick charts about investment risk, value investments are often businesses that, having had one near-death experience, are doing their utmost to avoid having another.
In other words, no matter whether their focus is global, regional or national, value investors’ portfolios should be full of businesses that are prudently managed, with solid balance sheets and limited debt levels, and thus well-prepared to weather whatever the future has in store.
Adding further to these defensive characteristics, value investors naturally aim to build in a margin of safety by buying companies on cheap valuations.
There are only equities that are too cheap or too expensive
As we have written before in pieces such as Three investment lessons, when it comes to investment, there are no equities that are always safe or always risky – only ones that are too cheap or too expensive.
As such, a business could have the most volatile earnings stream in the world but, if you buy it at a 90% discount to what you think it's worth, you are giving yourself a very good chance of making money from the investment.
By the same token, you could identify the business that boasts the most stable earnings stream in history and yet, if you pay 10 times what it is worth, you are highly unlikely to make money – indeed, you are more likely to end up losing money.
To us, that is the definition of risk and it has nothing to do with the supposed predictability and stability of an asset – only the price you pay for it.