Where value investing strategies still work

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The author is Founder and Chief Investment Officer of Verdad Advisers.

Poor performance hasn’t necessarily been a selling point for value investing strategies in recent years. Over the past 15 years, a string of poor performances has inexorably shifted investors away from a strategy that primarily invests in undervalued companies to a more growth-oriented approach.

This has hollowed out the value investing community. As far as I can tell, the world of value investment managers has shrunk to an older set of people whose pre-2009 track records were strong enough to maintain investor loyalty, quants who trust long-term data, and nervy guys with an obsessive obsession with natural resource stocks.

The recovery from the COVID-19 pandemic looks like a false dawn for the U.S. value community, as artificial intelligence fever sweeps the markets in 2023, restoring the fortunes of briefly disgraced growth managers and hurting once-optimistic value managers.

As figures from Professor Kenneth French’s data library at Dartmouth College show, the value “factor,” which measures the return on buying cheap stocks and shorting expensive stocks, fell by 50% in the United States from 2009 to the height of the COVID-19 pandemic in 2020. It then recovered sharply toward the end of 2022, but began to fall again shortly after ChatGPT was released in November 2022. Since then, the value factor has fallen by 11% in the United States. This is by no means an optimistic situation for proponents of value investing.

But it would be shortsighted to focus too much on the recent experiences of the U.S. value investing community, because the situation is markedly different internationally.

Value stocks experienced a similar sell-off as the US, dropping 30% during the COVID-19 pandemic. However, since March 2020, performance in non-US developed markets has risen steadily, almost linearly. International value stocks also performed well during the ChatGPT era. Outperformance since March 2020 has been very good, with value stocks now showing outperformance over 3-, 5-, 10- and 15-year periods. Value stocks are up 36% in non-US developed markets.

So while many assumed it was worthless, it turned out the value was actually on a plane heading to Europe and Japan.

Those arguing for the demise of value, and the abandonment of value in the US, must address this strong international performance: if value is a statistical outlier and not worth betting on, why have people made profits by betting on it internationally?

If something structural has changed in the markets that has caused value to stop working, why did it only affect the U.S.? If quantitative investing is too simplistic and simply buying the cheapest stocks is a stupid strategy, why do fools who practice this approach outperform in Europe and Japan?

I argue that the best interpretation of this data is to view the underperformance of value stocks in the US as historically contingent, dependent on the occurrence of a particular series of events. And that series of events is major technological innovation, first in cloud computing and more recently in AI.

This enables the companies with the best technology to grow globally with near-zero marginal cost, creating winners who can grow profits at a speed and scale that would have seemed impossible in past decades.

But history shows that markets tend to adapt to technological changes: competitors learn the new technology and lower their prices, and companies in other industries adopt the new technology and use it to improve their own operations.

It’s not hard to imagine how this works with AI: initial profits go to the first company that invents a working AI system (e.g., OpenAI), but then over the next 3-5 years, competitors emerge that create the same technology, driving down the price and profit margins for the innovator. Then, perhaps, a group of boring old companies with large customer service departments adopt the AI ​​technology, dramatically reducing their headcount and improving their profit margins.

While early equity returns flow to the innovator, long-term benefits can accrue to the customers of the technology, and economic theory dictates that at a minimum, customers should get a return on their investment that exceeds the amount they spent on the new technology.

While the sun may be setting for U.S. value investors, dawn is breaking internationally, and theory and evidence suggest that the sun will probably rise in the U.S. sooner than expected.