Why value investing will deliver higher returns with lower risk

I’m a big advocate of value investing. If you buy high a quality investment for fair price and hold it for the long run, you can’t help but make a lot of money. But if you can buy the same quality asset cheaply (below its intrinsic value), then it’s likely that you will make even more money. This is what value investors attempt to do.  

You can adopt a value investing approach with many asset classes, which I’ll discuss later. However, for most of this blog, I’ll use shares as an example because there’s a lot more data available.

How does value investing reduce your risk?

When investing in an asset, you can derive an investment return in two ways; by receiving income and/or the value of the asset appreciates i.e., capital growth. Often, assets provide a combination of both income plus growth.

Receiving income is less risky because you ‘bank’ the return each year. That is, you are less reliant on capital growth to generate an acceptable overall return.

Your capital return will depend on two factors. Firstly, what you paid for the asset (to purchase it). And secondly, the assets future value. Of course, overpaying for the asset initially will diminish future capital returns. Overpaying slightly for a high-quality asset probably won’t have a material impact on future returns, as a quality assets growth with quickly make up for any small overpayment. But a material overpayment and/or buying a poor-quality asset is a big problem that will cost you dearly.  

Conversely, if you buy a quality asset for a cheap price, you are less reliant on the overall market organically driving prices higher to generate quality returns. In fact, in this situation, your future capital growth will come from two sources: the appreciation to fair market value, plus organic growth.

A quick history lesson…

The chart below compares how value has performed compared to growth in the US share market since 1979 (using the Russell 1000 indexes). They have performed similarly over the long run i.e., growth has returned 11.3% p.a. and value 11.6% p.a. However, recent performance has been a lot different. Between 2018 and 2021, growth substantially outperformed value as it returned 24.1% p.a. versus 10.5%. Consequently, by historic standards, value is now relatively cheap.  

value investing versus growth

Why do I think value is likely to outperform over the medium term?

There are two predominant reasons that I think a value approach/methodology is likely to deliver above average returns over the medium term (5 to 10 years).

Firstly, mean reversion is likely to continue to drive higher returns. This has already started to happen. Value outperformed growth by more than 21% in 2022. History suggests that growth will continue to struggle especially since growth has been dominated by only a handful of mega-cap stocks (Apple, Microsoft, Google, Amazon, etc.). This empirical research indicates that mega-cap stocks rarely continue to outperform forever – their performance eventually lags. If history is any guide, it is likely that most of these mega-cap stocks won’t be in the top 10 most valuable companies a few decades from now.

Secondly, a higher interest rate and inflation environment is more challenging for growth stocks. It is not uncommon for growth stocks to burn through cash because they are investing in their business (not always wisely) to generate more growth. In fact, it’s entirely possible (or likely) that growth companies are not profitable. Therefore, they need an endless source of money (debt and/or equity) to fund growth. In a higher interest rate environment, that is a lot more expensive and difficult to do. It seems that over the past year the market’s sentiment has changed. The market seems more willing to focus on business fundamentals (profit, cash flow, strong balance sheets, low debt, etc.) and not get carried away with (often irrational) growth stories, like it did during 2020.

Finally, it is very likely that company earning will decline over the next couple of years due to higher interest rates and potentially a recession. Adopting a value approach helps to somewhat reduces your downside if you have invested in companies that are already trading on low multiples.  

How can you invest in value?

There are two ways to skew your investments towards value using low-cost, evidence-based methodologies:

  • You can use an index fund that invests in an index that meets certain value criteria (e.g., stocks trading at attractive PEs and/or Price/Book ratios). Two examples of these are VanEck MSCI International Value (VLUE) and Vanguard Global Value Equity Active (VVLU). Unfortunately, there aren’t any Australia value ETF’s at this stage, although I understand that fund manager, Dimensional will soon launch ETF’s in Australia. It operates an Australian value fund.
  • You can target market sectors that you feel exhibit good value by using various index methodologies, other than traditional market cap indexing. For example, if you think small and mid-cap stocks are attractively valued in a certain market, you can use an equal weight index methodology. In addition, you can also target geographical markets that appear to be cheap by historical standards (e.g., UK or Europe).

Where are the best value opportunities in share markets?

US firm, Research Affiliates publishes a model that uses peer-reviewed methodologies to predict 10-year future returns for various asset classes. One of the core methodologies utilised in its models is the CAPE ratio, which has a strong correlation (approximately 70%) with subsequent returns. So, it’s not a perfect predictor but it’s certainly a very useful tool. Using Research Affiliates’ model, the following markets appear to be the most attractive (the table sets out future 10-year return ranges with the low end having a 75% probability of occurring and the high end a 25% probability).

Most attractive markets

Whilst there are no guarantees, my view is that skewing an investment portfolio towards the sectors that appear to be good value not only reduces your risk but also exposes your portfolio to potentially higher future returns.

Value investing with property

Whilst most of this blog has been focused on value investing in share markets, it is possible to be a value investor in other asset classes too. As I have previously discussed here, the investment-grade apartment market in Melbourne still represents the best value in my view.