Morningstar - Q3 2020 - 57

data, which starts in 1925, this value drawdown
we've had since January 2017 is the worst one,
and it now has the longest duration.
Part of this is that value is inherently
cyclical and tends to perform the worst during
economic slowdowns and contraction-
which is where we are today, and we've been
in a late-stage environment for the past
couple of years. All the other bad episodes for
value-the 1930s, the early 1980s, the late
1990s-have also corresponded to very late-stage
economic cycle contractions. Value tends
to perform best coming out from the bottom of
economic troughs. Value companies have
operating leverage, which makes them very
efficient, and they tend to do very well in the early
parts of the cycle.
Andrea Frazzini: You are right, Alex, that
value investing is fairly intuitive. When you have
two companies with very similar cash flows
or earnings or revenue into the future, and one
of them is trading at a lower price relative

to the other, you expect to have a higher return
if you buy the cheaper company.

up at the bottom, which accounts for some of the
outperformance more recently.

What can go wrong? Two things: Either your
forecasts of future long-term cash flows are wrong
or prices take a long time to converge-they
can even diverge in the short term. Over the past
few years, there's not a lot of evidence that
the fundamentals have been moving in a way
that is extremely abnormal relative to history. But
we have seen systematic evidence of prices
really deviating from those fundamentals. That
has led us to the recent situation where the
spread in valuation ratios between cheap and
expensive companies has reached historically high
levels, levels that we haven't seen since the
peak of the tech bubble at the end of the 1990s.

To look at the structural issues, it's informative to
think about the other episodes where value
performed badly. The late 1990s was the age of the
Internet, which connected us all and completely
changed our lives. The 1980s saw the rise of
free trade and globalization, and it was the era of
the personal computer. As for the 1930s,
we remember the massive company failures and
record unemployment, but it was a time of new
growth, too. We had the rise of modern entertainment, of movies and radio. We use the term
soap opera because Procter & Gamble PG started
those in the 1930s as radio serials to sell
consumer products, such as soap. Disney DIS and
HP HPQ started during these downtimes as well.

There are lots of different ways of measuring
valuation spreads. You can look at different types
of value portfolios or different measures. You can
adjust for industry. But the overall evidence
shows that value stocks are very cheap. Over the
past couple weeks, the spread has come
down a bit, but even with that slight rebound for
value, I would say it's still in the ballpark of
what we saw during the tech bubble.
Ang: Since the bottom of the stock market
on March 23 to the close on June 5, we have seen
quite a remarkable turnaround in value. The S&P
500 from that nadir of stock markets is up
around 40%. Value has outpaced the market and
is up more than 6% above momentum.

Is This Time Different?
Bryan: That gets back to the cyclical issue: A lot
of value companies seem to do better in early
parts of a recovery, such as after the recent coronavirus
sell-off. But the past 13 years or so have been
a challenging time for value. What are the structural
issues playing into this?

Andrea Frazzini, principal and head of global
stock selection at AQR Capital Management.

Ang: Some of this is absolutely cyclical.
We moved firmly into contraction in April. Value
companies only manufacture one good or
one type of service. They have inflexible business
models and tend to underperform during
a late economic cycle or entering into a contraction. But those economies of scale give them a leg

What's common to these periods is an acceleration in the decline of industries. In the Great
Depression, it was things like textiles and
leatherworking. Today, it's old-fashioned retail. But
we also see massive shifts in technological
adoption or types of things that have increasing
returns to scale. Today, we're undergoing
something similar.
The rise of intangible assets is economywide. In
the 1990s, papers by Janice Eberly and other
macroeconomists estimated intangibles at around
10% of total firm assets. In the late 2010s,
this reached close to 15% - 20%. Today, the fraction
of intangible assets is over 40% in sectors like
technology. It's hard to think of a great company
today that doesn't have large amounts of
intangible assets. But these are harder to estimate
with traditional balance sheet and earnings
statement information, so we have to start
exploring different value metrics.
Bryan: The world has certainly changed over
the past few decades in ways that critics of value
investing would argue reduce its efficacy.
There is the rise of intangibles. There are structural
headwinds facing value-oriented sectors like
energy. In financial services, you hear about the
impact of low interest rates. The market is
becoming more competitive as access to information
becomes more widely disseminated. So, is this
time really different?

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