On 13th May, Prof. Aswath Damodaran blogged, among other things, that old style value investing is dead. This led to a lot of noise on social media and even mainstream media that another stalwart has given up on value investing. For once I thought people misunderstood what the professor had said. But then I read the actual post. This is what he wrote:
For decades, we have accepted a lazy categorization of stocks on the value versus growth dimension. Stocks that trade at low PE or low price to book ratios are considered value stocks, and stocks that trade at high multiples of earnings and book value are growth stocks. In fact, the value factor in investing is built around price to book ratios.
I think this is based on a limited understanding of systematic value investing. Now, I am a big fan of Prof. Damodaran. His super systematic approach to valuation, with thoughtfulness about every single aspect always blows my mind. I also greatly appreciate the importance of stories that you bring to any valuation. But somehow, his statement above seems to reflect a blinkered view about quantitative investing – at two levels.
Systematic Value Investing
Anyone who follows the quantitative investing literature today knows that no meaningful value investing strategy relies solely on one ratio. Even the most basic strategies combine multiple factors to compute value scores. These include a variety of yield ratios such as dividend yield, free cash flow yield, earnings yield and even forward earnings yields etc. So even if book value may not reflect the true value of a company’s assets, the earning power that such assets produce should be reflected in the price. A price to book metric today constitutes only a small weight in the value factor computation.
Similarly, the growth factor is not computed as the inverse of the value factor. Growth is measured objectively as growth in revenues, earnings per share, sales, etc. So it is not impossible to build a portfolio of growth companies that satisfy some value criteria as well. Further, systematic value investing strategies overcome these types of distortions in valuations (P/B) by portfolio construction methods that compare valuations of relatively similar types of companies. Quant investing may have been born in Fama and French’s era, but it has not stood still over the decades.
The second aspect that he fails to consider is the statistical nature of quantitative investing. The point of all quant investing is base rates. Even if a handful of companies may not fit the traditional mould of value, the point of this strategy is that over a large enough sample, buying “cheap” is likely to fare better than buying “expensive”. The fact that markets routinely overestimate growth and overpay for assets has repeatedly been demonstrated. So even if you might come up with a justification in this or that case, on average, an expensive stock on traditional metrics is still likely to under-perform.
Is it really dead?
I cannot do justice to explaining why systematic value investing is not dead. Thankfully, I don’t have to. Giants of the quant investing fraternity, Ronen Israel et al of AQR, have laid out a beautiful empirical case. Cliff Asness has also written a very detailed blog post detailing the studies they conducted into this very theme. These are not to be missed.
I have always maintained that there is a large variety of ways to make money in the financial markets. Whether you’re a technical trader, a long term investor, a distressed assets investor, or a quant investor, pursuing your craft with discipline and intelligence yields results. Systematic value investing may have been going through pain over the last decade, but I very much doubt it is dead. If you’ve been lazy about how you do value investing, though, your game may indeed be up.