The Structural Return Argument Against Value Investing

The Structural Return Argument Against Value Investing | Philosophical Multicore

The Structural Return Argument Against Value Investing

Value investing had a singularly bad run from 2007 to 2020. (And it hasn’t done great since 2020, either.) Is that because value investing is broken, or did it simply hit a streak of horrendous luck?

Skeptics of value investing have made many claims about why value investing doesn’t work anymore, but these claims tend to be light on evidence.1 Value investing proponents have empirically researched most of these claims and found that they don’t stand up to scrutiny.234

The poor performance of the value factor was not primarily driven by weakening fundamentals, but by the widening of the value spread. A wider value spread makes value investing look more attractive going forward, not less.

What's the value spread?<br>Value stocks are defined using the ratio of a stock’s price to some fundamental metric—for example, earnings, book value, or cash flow. If we use earnings as the metric, then value stocks are those with low P/E ratios and growth stocks are the ones with high P/Es.

The value spread is the ratio of price-to-fundamental ratios between growth stocks and value stocks. For example, if growth stocks have an average P/E of 30 and value stocks have an average of 15, then the value spread is 30/15 = 2.

All else equal, a wider value spread is good for value because you’re buying the same fundamentals at a lower price. However, a widening spread is bad for value because it means value stocks are declining (relative to growth stocks). This is analogous to how bond investors like when bond yields are high, but they lose money when yields are increasing.

I wouldn’t dismiss value investing on the basis of poor recent performance.

However, there’s a potentially strong argument against value investing that remains unrefuted.

Historically, the structural return of the value factor—the component of return that comes from company fundamentals, rather than changes in the value spread—was about 4–6%.4 But over the past two decades, that number has averaged a mere 1%. Unlike with the value spread, a muted structural return does not imply higher future expectations for value investing.

In this post:

Pease (2019)3 and Arnott et al. (2021)4 broke down to the value factor into a valuation component and a structural component. They found that most of the post-2007 underperformance was driven by widening valuation, but the structural return also declined. However, the decline was not statistically significant. [More]

Using a longer dataset back to 1927, I find that a low structural return is not unprecedented—something similar happened in the 1940s. [More]

The structural return can be separated into growth + dividend income + migration. The first two components are easy to explain, but the (small) decline in migration return is puzzling. [More]

If the decreased migration return isn’t just random chance, then the most likely explanation is that the market is rationally reacting less to fundamentals surprises, which would indicate that the reduced migration return is likely to persist. [More]

The appendix of Arnott et al. (2021)4 finds that the recent muted structural return is not statistically unlikely, and may be explained by selection bias. [More]

Contents

Contents

Explaining the performance of the value factor

Has the structural return ever been this low before?

Elements of structural return

Going deeper on migration<br>Have fundamentals surprises shrunk?

The market’s reaction to surprises

Arnott et al.’s statistical argument

Conclusion

Appendix: Source code

Changelog

Notes

Explaining the performance of the value factor

The value factor is measured by a stock’s price-to-fundamentals ratio, using some measure of fundamentals like earnings or book value. Value stocks have low P/F ratios and growth stocks have high P/Fs.

The performance of value stocks can be decomposed using a short equation:

\[P = \displaystyle\frac{P}{F} \cdot {F}\]

P/F is called the valuation component, and F is called the structural component (the part that comes from the underlying structure of the economy).

For the return of value stocks relative to growth stocks, we can look at the relative change in P/F and the relative change in fundamentals. Did value stocks underperform because their fundamentals did particularly poorly, or because the spread in P/F multiples expanded—with the value stocks getting cheaper, and the growth stocks getting more expensive?

Arnott et al. (2021)4 looked at this question (using book value as the measure of fundamentals). From 2007 to 2020, the total return of value minus growth was –6.1%. Arnott et al. found that value’s negative premium was more than fully explained by expansion in P/B, and value companies still outperformed growth companies on the structural component:

1963 to 2007: 6.1% return = 0.2%...