Is Value Investing Back From The Dead?

It seems value investing has staged a remarkable turnaround in recent times. It’s kind of like what happened to John Travolta’s career after he did Pulp Fiction.

I originally started thinking about this when I came across the performance figures for the Vanguard Global Value Equity Active ETF (ASX Code VVLU).

55 percent! The year-to-date and 1-year figures are very impressive (although the 3-year figures leave a little to be desired). The benchmark, in this case, is the FTSE Developed All-Cap in Australian dollars Index - that's a bunch of companies mostly listed on stock exchanges that aren't in Australia.

As I was perusing these figures, I wondered whether value investing’s long-awaited day in the sun had finally arrived after having been maligned by stock market investors the world over for what seemed like an eternity.

I was also interested in how this has played out in an Australian context. Fortunately, the good people at S&P have created an index called the S&P/ASX 200 Value Index which tracks the share price performance of the companies in the ASX200 index which S&P considers “value stocks”. To do this it uses three common value factors - price to book, price to sales, and price to earnings.

Over 3 years we can see the value index lagged with an annualised return of 9.33% compared to the ASX 200 index performance of 12.15%.

But over one year, we can see the tables have turned.

The value index outperformed with a return of 34% compared to 26%. I should note here that I used the “Total Return” index in each case so as to include dividends.

So is value investing back, or is this just some post-covid hiccup that will pass quickly as growth stocks resume their skyward trajectory? That is the 64 thousand dollar question.

Or is it?

One of the problems with value investing is that there’s no generally accepted definition. According to Wikipedia:

"Value investing is an investment paradigm that involves buying securities that appear underpriced by some form of fundamental analysis"

That's fine as far as it goes, but what do we mean by underpriced? And some form of fundamental analysis sounds a bit vague as well.

Some common shortcuts to fundamental analysis which get scribbled onto the valuation yardstick include price to book multiples and price to earnings multiples (both of which are used when constructing the S&P/ASX 200 Value Index). The problem with these shortcuts is while it will identify optically cheap companies, these companies are often cheap for a reason.

Famed value investor Warren Buffett is quoted as saying

“It’s far better to buy a wonderful company at a fair price, than a fair company at a wonderful price.”

This starts to get a bit harder. Instead of just running a stock screen, buying a dozen of the cheapest companies then kicking back and watching Netflix, we need to look deeper and understand each of the businesses as well. Maybe that stock trading on a PE multiple of 20 is better value than the stock trading on a PE of 10.

But we can also fall into a trap when searching for wonderful companies. Warren Buffett again - 

“For the investor, a too-high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favourable business developments.”

I would argue many so-called wonderful companies are parading around on the ASX at nosebleed valuations (I’m looking at you Xero with your 2,292 price-earnings multiple - but you're far from being alone up in the stratosphere) where there is a reasonable chance that even with outstanding business performance, investment returns to current holders will be less than satisfactory.

So I think this calls for a middle way - a path which steers clear of value traps yet avoids the siren song of those so-called wonderful companies where the slightest stumble will see today’s astronomical valuation multiples collapse to something more realistic (while taking a decent bite out of shareholder returns as their prices tumble).