FOR MORE than a century scores of investors have prospered through “value investing”, or buying shares in firms which appear cheap given their “fundamentals”. Warren Buffett, an eminently quotable value investor, summarised the approach succinctly: “Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”
Although many value investors, including Mr Buffett, have done well in the long run, they have had a rougher time over the past decade. You can gauge just how pricey a stock is by looking at its price-to-book ratio, which measures how much the market thinks a company is worth relative to the net assets on its balance-sheet. Since 2010 the Russell 1000 value index, which tracks American stocks with low price-to-book ratios and low expected earnings growth, has risen by just 87%, compared with 171% for the market overall. Rather than falling back down to earth as value investors might have predicted, shares in the priciest American companies in 2010 have for the most part kept soaring.
According to AQR Capital Management, an investment firm, the price-to-book ratio of the most expensive third of American stocks was around five times that of the cheapest third in 1967. That ratio has climbed steadily ever since 2015, and hit a record high of 12 times in March, when their analysis ended.
The pandemic has only widened the gap between the most and least expensive stocks. Much to the surprise of many financial commentators, shares in big American firms are actually up on the year. A closer inspection reveals a bifurcation in the market. While shares in fast-growing companies with high price-to-book ratios have risen by around 20% since early January, shares in value firms are down by over 10%.
One obvious explanation for all this is the rise of tech firms, which are difficult to analyse using standard valuation tools. For instance, measures like book value may not accurately capture companies’ intangible assets, such as the strength of their brands or the value of their intellectual property. Moreover, unlike value firms, big tech companies tend to form natural monopolies which protect them from competition, boosting their prospects.
Yet the tech theory crumbles under careful scrutiny. AQR’s data show that pricey stocks have outperformed, even when excluding tech firms or the biggest 5% of companies by market capitalisation. Nor can the inadequacy of book value be blamed, since investors also appear to be willing to bid up shares in companies with high price-to-earnings ratios.
It is possible that investors are simply overvaluing glitzy growth firms. Value stocks have been trampled before. They also severely underperformed growth stocks in the late 1990s and early 2000s, during the dotcom boom. Established firms simply did not hold the same allure as up-and-comers like Yahoo and Cisco, which seemed destined to take over the world, until they didn’t. Tech stocks gyrated wildly earlier this month, suggesting that investors are getting antsy about their high valuations. Redemption for the value-investing faithful may yet come. ■
Sources: Refinitiv; AQR
This article appeared in the Graphic detail section of the print edition under the headline “Value judgment”