Time to rewrite the rules of value investing?

Academics argue 'rigid and ritualistic' definitions underpinning traditional value approach must be discarded

Time to rewrite the rules of value investing?

While devotees and apologists for value investing have provided explanations for its long spell of underperformance, a pair of academics are proposing that the problem isn’t due to central bank intervention or unfavourable market cycles, but rather a staid view of value.

As reported by Institutional Investor, Brad Cornell of the University of California and Aswath Damodaran of New York University have published a new paper arguing that it’s time for investors to adopt a “more dynamic” definition of value.

“In the last two decades, value investing lost its edge, and a debate has revolved around whether this is a temporary phase, and the result of an unusual macro environment, or a reflection of a permanent change in economies and markets,” the pair wrote.

While they acknowledged that external factors may account for some failures of value investing, “many can be traced back to practices and rules of thumb that have outlived their usefulness.”

These “rigid and ritualistic definitions,” the two said, include an outdated conviction that tangible assets are a necessary component of value investments, which has kept many value investors away from technology stocks. By a similar token, a dogmatic focus on dividends has led to portfolios with concentrated exposures to utilities, financial services companies, and older consumer product companies.

In a solo paper, Cornell branded value investing as a “historical accident,” arguing that the methodology advocated by Benjamin Graham and David Dodd saw wide adoption because digital spreadsheet tools and handheld calculators were not yet available.

The lack of such tools, he argued, created an incentive to use “simpler metrics that could be calculated and compared quickly” such as price/earnings and price/book ratios. Academic work by researchers such as Eugene Fama and Kenneth French, he said, contributed to a widespread embrace of the traditional value definition among investors even as technological advancements should have enabled more sophisticated calculations.

“The demise of the value premium in the last 12 years has led to doubts regarding the efficacy of traditional value investing based on accounting ratios and an effort to adjust those ratios,” Cornell said, adding that “such an effort is misguided.”

Noting that traditional value investing essentially “[compares] estimates of fundamental value with price,” Cornell maintained that a full-blown discounted cash flow analysis, rather than just accounting ratios, is the key to estimating value.

Taking the argument further, he and Damodaran said in their joint paper that value investors implement other “fundamental” changes, such as a clearer distinction between value and price, employing risk measures aside from the margin of safety, and holding more diversified stock portfolios.

“The only reason for concluding that value investing is superior to any strategy is evidence that it produces superior risk adjusted returns,” the two said. “In light of the behavior of stock prices in the last decade that evidence is at best mixed.”