2022 has not been a pleasant experience for investors. In recent memory, bonds have provided a safe haven during equity market selloffs but 2022 has reminded us that bonds can be volatile as well:
2022 stands as a harsh reminder that diversifying among two separate asset classes may not always provide enough diversification to shield portfolios from turbulent times. There are alternative assets that investors can choose to add to their portfolios, but what about diversifying within an asset class itself? We will leave the alternative investment discussion for a later date but let’s focus in on diversifying risk within an asset class such as stocks or bonds.
The Dimensionality of Markets
The above return numbers are calculated based on long / short market exposures and are arithmetic return figures. These figures should be taken with a grain of salt as this will overstate the historical returns that investors could harvest from the markets. These figures are also before trading costs and taxes.
Both the academic and institutional money management world have identified patterns in stock returns throughout time that have persisted across different economic regimes and multiple countries (not just the US). Whether or not these return patterns exist because of additional market risks or investor behavioral biases remains as one of the great debates in academic finance. At Meredith Wealth Planning, we believe that both parties deserve a seat at the table.
From the chart above, you will notice that value stocks have historically provided a premium in the stock market for investors to harvest over time. Value investing has been around for decades and was first popularized by Ben Graham back in the 1920’s and 30’s.
It was one of Ben Graham’s students while teaching at Columbia that eventually brought value investing into the mainstream finance media years later.
The story is well known at this point but after being rejected from Harvard University, Warren Buffett found out Ben Graham was teaching at Columbia and enrolled to study under him. While at Columbia, it is said that Buffett was the only student to ever receive an “A” from Graham in his class.
Buffett went on to utilize Graham’s ideas on valuing a company and incorporated the underlying fundamentals in a company’s earnings, cash flows and profitability. Along with a little bit of leverage from the insurance businesses he would buy and a 70 plus year investment horizon Warren Buffett grew his holding company (Berkshire Hathaway) into a behemoth from simply paying attention to the price you pay for an investment and the quality of that venture. Eventually, the academic and quantitative investment world caught up to Graham and Buffett and developed methods to implement similar strategies using modern computers and data analysis. This is the birthplace of the modern value, profitability and quality premiums we noted in the table above.
Value Investing Leading up to 2022
Value investing is not a free lunch where you easily earn excess returns over the market. The chart below highlights how painful value investing has been over the past decade.
The most recent decade ending in 2020 was the worst 10-year performance for value investors on record going back to the 1930s. Where did that put us heading into 2022 calendar year?
Cliff Asness and the research team at AQR put together a measure of the “value spread”; basically, how large of a divergence there is between cheap and expensive stocks in the market. As we can see highlighted in the chart above, the value spread began to widen rapidly beginning somewhere around 2018. Basically, expensive stuff became even more expensive while cheap stocks remained cheap. Many had pronounced value investing as a thing of the past in a new world where innovative and disruptive companies would take over.
2022 & Value
We notice a reversal of fortunes for dedicated value investors in 2022 along with 2021 as well. These figures are once again academic figures that are pre-tax and trading costs. Many value strategies are not up nearly 30% on the year but these figures do show us that value is working and working quite well.
To get a better idea of how real-world value investors have fared in 2022, let’s look at some “value factor” funds and analyze their year-to-date performance versus the S&P 500:
Note: Meredith Wealth Planning uses Avantis and Dimensional funds in constructing client portfolios, but one should not accept this blog post as any sort of recommendation and should consult with their own qualified investment professional before implementing any strategy.
We observe that the returns of the funds are still negative on the year (not the 29.49% positive gain noted in the raw factor returns); however, given the large losses on the broad stock market measured by the S&P 500 index, we can certainly see that the value stocks have experienced far less pain this year compared to the more expensive areas of the market. There is no company so great, that paying too high of a price for it won’t ruin the outcome.
Diversify across factors
Investors should look beyond only diversifying across asset classes to reduce risk and balance risk within specific asset classes such as equities and bonds. Factor investing (also called dimensional investing, characteristic investing, smart beta, style investing etc.) is a systematic way to measure this risk and harvest returns within a specific asset class. 2022 is a great example of this theory in practice as investors who tilted their equity portfolios into value and quality have experienced a smaller drawdown recently and earned higher risk adjusted returns over longer time periods (20+ years).
Value is not a recession hedge
Tilting a stock portfolio into value-oriented equities is not a panacea to economic recessions and market drawdowns. I must confess that 2022 has been a bit of an anomaly here and I’m not pitching value as a means to reduce stock market drawdowns. If value stocks earn a higher return due to higher risks, it only makes sense that they struggle during most market downturns when economic risks show up.
EBIT / TEV = Earnings before Interest and Tax / Total Enterprise Value & Book Value and Cash Flow are balance sheet and GAAP accounting terms
Value investing is not “anti-growth” investing
Many people would assume that the opposite of value investing is growth investing. Value investors simply focus on paying an attractive price for a company. Growing profits and cash flows are beneficial to all investors, especially those that paid an attractive price for an ownership interest in those profits. Value investing is the “anti-expensive” investing strategy, not anti-growth.
Is it too late to jump on the value investing bandwagon? Fortunately, history shows us that the recent performance of the value premium has no relevance on the performance of value stocks in the coming years.
AQR recently updated their value spread measure and as of August 2022, things still look pretty rosy for value-oriented investment strategies going forward. Investors would do well to look beyond owning broad market indexes and tilt into known and proven dimensions of risk and returns. Volatility is often the enemy of portfolio growth and allocating to multiple premiums within your portfolio can help weather the storm.
Disclosures: This article is for informational purposes only and should not be considered a recommendation. Information contained in this article is obtained from third party resources that Meredith Wealth Planning deems to be reliable. Consult with a financial advisor before implementing any strategies. Past performance does not equal future results. Meredith Wealth Planning does not guarantee any minimum level of investment performance or the success of any index portfolio, index, mutual fund or investment strategy.