Value stocks and junk bonds

The foundation of value investing lays in the notion that cheaply priced stocks outperform pricier stocks in the long term. Value is multi-faceted: the stock price as a multiple of company earnings, price as a multiple of dividends, price over book value, and many other fundamental ratios exist to define value. Many institutional investors use this approach to identify assets that they expect the market to revalue. In addition, decades of research has shown that the value factor is a robust one, and that value stocks outperform growth stocks.

However, last year was a bad year for value investors. The Russell 1000 Growth Index outperformed the Russell 1000 Value Index by 9.8 percentage point. In fact, value investing has been underperforming relative to growth investing over the past 12 years. Over the last ninety years, similar episodes occured only twice: during the Great Depression (1930s) and the Dot-Com bubble (late 1990s), as can be seen in the plot below (source: Kenneth French’s database). 

The decline in the value premium is, in particular, a plague for quantitative funds. Whereas discretionary asset managers have the flexibility in executing their mandates, quantitative asset managers implement systematic fixed investment strategies. These asset managers often argue that the value premium is robust over time, dating even back to the 18th century, and among the most rigorous among all factors.

 

 

A natural question to ask then is whether the “value premium” is dead. A survey, conducted by the Bank of America, shows that a mere 2% of the fund managers expect value to outperform growth in the next 12 months the least since 2010. There is a growing structural suspicion that the value factor may be broken. However, as the value’s history has shown, there is nothing new about its latest disappearance. The value premium fluctuates over time, and may therefore also vanish occasionally, sometimes even for a prolonged period. 

What strikes me more is that, although value seems to be “dead”, faith in junk bonds remain high. If value stocks underperform, why do junk bonds outperform? Essentially this is the same investment but in a different part of the capital structure of the firm. When a firm, with value-like characteristics, issue corporate bonds, they are more likely to receive a worse credit rating than a firm with growth-like characteristics. Bond investors buy these bonds because junk bonds provide a higher yield, partially such firms have a higher risk of default. Arguably, the value premium exist also because some firms have a higher default risk than others. In addition, firms with junk bonds are also more likely to be listed in a value index. The median price-to-book ratio of firms with a junk rating (BB or lower) is 17% less than those rated as investment grade. For price-to-sales this is even 63% lower, and for price-to-cash 35%. Buying junk bonds implicitly exposes ones portfolio towards value.

One should rather ask: if the value premium is dead, why are junk bonds so attractive? One argument that is often used to justify the absence of a value premium is that value investing is overcrowded, often due to ETFs. Another argument is that value firms can’t compete with the innovation and technology of growth firms. However, if these arguments were true, then there would be no junk premium at all. 

It is not clear why the value premium is marked for extinction. As seen before, value has been known to vanish for years before reviving again. Those who believe that the value premium is dead should rather ask whether else in their portfolio will be marked for extinction. 

Amar Soebhag