They don’t think it be like it is, but it do.
– Oscar Gamble (1949 – 2018)
I’ve always loved this beautiful line from Oscar Gamble – who, sadly, passed away earlier this year. I referenced it in the first of my Things that Matter series last year, a note called Whom Fortune Favors. The gist of it is: when we are active in a specialized field for a very long time, or when we have a highly technical understanding of a narrow field, we often miss what should be obvious truths about that subject staring us in the face.
For Oscar Gamble, that obvious truth was dysfunction in the Yankees clubhouse and racism in baseball.
For many investors, as Ben discusses in Part 2 of his Things Fall Apart series, that obvious truth was the failure of diversification over the last 10 years.
For many other investors, as I’ve realized after reading the responses from subscribers to It Was You, Charley, a note I wrote about systematic and screen-based value strategies, that obvious truth seems to be a tougher one to swallow:
Value investing is price-to-book investing.
To those of us who have spent any time building factor portfolios, selecting descriptors, designing screens and the like, this is the kind of statement that makes our eyelids twitch. There may be sectors where book value still has some meaning. Maybe. But by and large, it’s an accounting abstraction, so divorced from any transmission mechanism to the generation of cash flow that it barely seems worth mentioning. There are a million descriptors for value which seem more sensible to us, and which our research indicate are probably more sensible.
But the way in which investors – retail and institutional alike – really access value as an investment style is heavily influenced by two things: the legacy of Gene Fama’s groundbreaking factor research, and the creation of the Russell 1000 Value Index. We can sit here and scream until we are blue in the face that value investing is what Benjamin Graham or Warren Buffett say it is, or that it is really investing based on price relative to some objective measure of cash flow, free cash flow or total shareholder yield metrics that incorporate debt paydowns and buybacks. But for most – not all, but most – of the conversations we have about value, we should be talking about the way in which it is bought and sold in actual portfolios. And that way is based on both indexes and active strategies that are heavily influenced by the price-to-book characteristics of Russell’s series of value indexes. We don’t think it be like it is, y’all, but it do.
Now, the point of the note, of course, was how concerned this makes me for many investors’ portfolios, especially in what Ben has referred to as a Three-Body Market. I am concerned that investors don’t seem to realize how long periods of value underperformance can be. I am concerned that investors don’t seem to realize how episodic and concentrated the periods of value outperformance tend to be. I am perhaps most concerned that the forms of value which are the most subject to abstraction – especially price-to-book – are the ones that most investors are emphasizing whenever their investment committees or home offices take a tactical bet for or against value vs. growth. Not because they ought to, but because the instruments that they use to do so are almost always designed that way.
This is why I think investors who are confident they can weather what may be, in our opinion, longer periods of value underperformance and outperformance, should still be focused on implementations that are less subject to abstraction. In particular, I’m probably willing to pay a little bit for a well-constructed multi-factor value portfolio that is nominally “active” over the traditional low-cost index sources that I would otherwise favor.
For Earlier Notes in the Three-Body Alpha series: