One of the most important stock-picking tactics ever invented — the ‘Holy Grail’ for value investors

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Picking "value" stocks hasn’t been a reliable way to invest for about 10 years, Bernstein analyst Inigo Fraser-Jenkins argues.
Value investing is one of the most basic strategies ever invented, a "Holy Grail" discovery that dates back to 1928. It relies on a standard principle of probability: "mean reversion" over time.
But today, cheap stocks stay cheap and expensive stocks just get more expensive, Bernstein’s research says. Mean reversion isn’t happening.
Tech stocks and quantitative easing have broken the underlying basis of the value proposition, Frasier-Jenkins argues.
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One of the most important investment tactics ever invented — "book value" stock-picking — may be fundamentally broken, according to a startling piece of research from Bernstein.

Bernstein analyst Inigo Fraser-Jenkins argues in a dense and theoretical research note that picking "value" stocks hasn’t been a reliable way to invest for about 10 years, he told Business Insider. His note begins with the stark question: "Is Value dead?"

Value investing is a fundamental concept you’re likely to learn in your first year at business school. The original idea was developed in 1928 at Columbia Business School by Benjamin Graham and David Dodd. The principle is simple: you figure out which stocks under-reflect the "book value" of a company based on its balance sheet, and then you buy those cheap stocks.

Over time, their price should move upward toward the average ("mean reversion") because lots of other investors are also trying to pick the cheap ones. Eventually, demand pushes up price and value investors make returns that beat the market.

A 91-year-old assumption may be at an end

For the past 91 years, investors have assumed that this is an equity market truism.

According to data collected by Fraser-Jenkins and his team at Bernstein, the value strategy may have stopped working sometime around 2008. He looked at the cheapest 20% of stocks and the most expensive 20%, based on their price-to-earnings multiples. Surprisingly, as this chart shows, the cheap stocks stayed cheap, and the expensive stocks just got more and more expensive. The cheap stocks continued to be priced at around five times their trailing PE multiples, pretty much where they were in the 1950s. The expensive ones went up to around 80 times.

Bernstein Research

That is a wildly counter-intuitive result.

It implies that the adage "buy low, sell high" has stopped making sense. Apparently, "buy high, sell higher" would have been a better strategy.

"The fact that the strategy has not worked for 10 years is having an effect on people’s careers"

"It’s one of the central questions in investing right now," Fraser-Jenkins told us. The failure of book value as a guide for picking underpriced stocks lurks in the background of every meeting he has with clients, he says. "For the last 10 years, this has not worked. The fact that the strategy has not worked for 10 years is having an effect on people’s careers."

He initially suspected that the rise of passive exchange-traded funds would be the culprit. ETFs are the most popular investment vehicle right now. You buy a weighted basket of stocks, often the S&P 500, and receive the overall performance of the market, for very low fees. ETFs tend to beat actively managed investment funds.

Could it be that the massive wave of money into ETFs was generating its own momentum, so that the more expensive stocks spiralled upward on their own, regardless of the underappreciated value of cheaper companies?

"The data doesn’t quite fit" for that to be true, he says.

Three variables are killing value investors

There are three other variables that do seem to be having an influence he says:

Ten years of central bank quantitative easing, low interest rates, and low inflation have led investors to use very low "discount" rates in their models. Discount rates are the estimate of how much the value of future cashflows will be reduced by inflation and other lost-opportunity costs. Low discount rates mean that estimates have become more accurate — because the margin for error, by definition, is less. And that has enhanced the value of companies whose models show robust growth in future cash flows. Those cash flows are worth more than they used to be. Book value is thus less of a factor.

The rise of tech stocks that have destroyed the protective "moats" of legacy businesses. Tech companies are different from traditional companies because they tend to generate binary results: They are either huge winners or huge losers, and the winners tend to win on a semi-permanent basis. There are only two makers of smartphone operating systems, for instance — Apple and Google. Huge winners have huge growth, with high future cash flows, explaining why tech stocks with high PE multiples continue to rise in price.

There has been a huge increase of companies carrying "intangible assets" which are not well-measured on their balance sheets. For book value to be a meaningful metric, it must accurately reflect the assets the company owns. But more and more successful companies are simply brands providing services, or content, or software, and they don’t own hard assets like factories or land. Tech companies reinforce this trend. And the assets on their balance sheets are thus a poor reflection of their actual value.

These factors, among others, are disrupting the mean reversion you’d expect to see in stocks that are over- or under-priced on paper.

What if stocks don’t revert to the mean?

That, Fraser-Jenkins argues, turns everything on its head. Mean-reversion is one of the most basic principles of probability: It describes the way, over time, results tend toward the average. For investors, buying something low and waiting for it to move upward toward the average of similar stocks is the basis of value investing. It is a "Holy Grail," Fraser-Jenkins says.

He is now suggesting that mean-reversion no longer works, at least for value investors. "Mean-reversion is a critical process in finance. Without it we are left having to rely on forecasts," he told clients.

There is one factor that could reinstate value investing’s importance, Fraser-Jenkins says. If inflation and interest rates go up, that will increase bond yields and increase discount rates. It might suck money out of equities and make the remaining money work harder to find opportunities — especially if higher discount rates render future cash flow estimates less reliable.

Don’t hold your breath.

With the Bank of England, the European Central Bank, and the US Fed all keeping their low rates on hold, it does not look like interest rates will be pushing up yields and discount rates anytime soon.

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