As quickly as it came, the retail rally may be over. A sure sign of a bubble is if your mom calls to ask about GameStop (GME) shares it may be time to stay away. Of course, as I mentioned in my last post, if there is mis pricing in the market, skilled investors should be able to take advantage of it, which it seems many did. Clearly some of the unsophisticated investors were also able to make a profit but the market doesn’t care who it pays. As long as those traders are right it doesn’t matter how they came to their conclusion.
The names of the hedge funds that are smarting from the GameStop debacle keep rolling in: Melvin, Citron, Renaissance and Point72 among others, have been named as funds that lost money on GameStop and other troubled stocks like AMC and Blackberry. The traditional narrative is that the leaders of these funds are tycoons who reap billions from the market and squash the little guy under their feet in their relentless pursuit of ever more profit. The reality is very different. For the past decade, after their dizzying ascent prior to the financial crisis, hedge funds have been closing about just as fast as they have been opening, most have underperformed the wider market and a traditional area where they have added value through research and activist investing has taken a nosedive: value investing.
Value as a strategy has been struggling for over a decade. Value is often compared against growth investing. When times are good and the economy is expanding, growth stocks tend to outperform value. When times are more difficult and the economy is sluggish, value tends to outperform. Recently, with the exception of a year or two since the financial crisis, value has underperformed growth every year across large cap, mid cap and small cap stocks.
Over a 10 year period, value has lagged growth by as much as 150% in terms of the cumulative 10 year return.
If you look closer at these heat maps from Morningstar, you may notice something: although there are long periods of underperformance, we started the decade with a 10 year period of outperformance for value. Although the outperformance wasn’t as great for large cap stocks at 14%, small cap stocks saw a 45% outperformance over the decade from 2001 to 2011. This happened to be not only a terrible period for growth stocks but a terrible period for stocks in general. It’s often been called the “lost decade” for stocks but this was also a decade when hedge funds thrived. When the wider market is growing gangbusters, it doesn’t tend to attract retail investors to speculate. They often stay to the sidelines and prefer the predictability of cash. Yet there’s a plausible argument that the outperformance of value over this decade played into the hedge funds hands.
Smaller stocks are not as well covered by analysts at large banks which produce research. That means they are often overlooked by institutional investors who are managing large sums of money where a small cap stock returning an excess to the wider market may not make much of an overall impact for them. Hedge funds, with smaller pools of cash and doing their own research, have the freedom to take advantage of the lack of available information which tends to be more common for small cap stocks. It may be one reason small caps were able to outperform large caps in the value theme by so much.
To add to what they already do, hedge funds can achieve these returns using leverage, which may juice the returns they could get from a value strategy in tough times. Just being 50% leveraged over a long period of time could turn that small cap cumulative 10 year outperformance from 45% to 90%. This equates to an annual outperformance compared to growth of 6.6% over a decade, this the type of eye popping outperformance that can get people’s attention.
The Growth Supercycle
Value’s underperformance has become predictable since then. 2020 proved to be the worst year for value compared to growth since 1999. In previous posts I have discussed why this could be a sign of growth being too hot and the time for some mean reversion with value to come back around. The funds that have survived this “lost value decade” for hedge funds may be those that are able to incorporate growth or maybe just made up of those that are good at marketing to their investors, convincing them to stick around despite year after year of underperformance. Just like in other industries, the largest and most liquid are likely better to be able to manage the storm while the other funds fail around them. This also creates an environment for them where they can get lazy. Getting lazy can produce behavior like herding: doing a trade because everyone else is, in this case because other hedge funds are doing it. This may have been the case for GameStop, which was one of the most shorted stocks on the market before Reddit traders piled in.
This was a big wake up call for the largest funds. They had a new type of investor to take into account and there is also a dark horse argument developing on what was behind the GameStop rally: that it was driven by hedge funds themselves. Some speculated that retail investors in no way could push up a stock’s market cap from a few hundred million to $20 billion within a few days and that there must have been hedge funds on the other side of this trade pushing it along.
Whatever the reasons it has touched of a surprising renewed interest in value. Yet the renewed interest in value may not be enough to keep the momentum going. A relatively new twist on value may be what is needed to renew sustained interest in this style of investing.
A Tweak to Fama French
A recent paper released for the National Bureau of Economic Research (NBER) argues that there is an important component that isn’t being taken into account in traditional value models that underpin value indexes. This factor is intangible assets. Traditional value, which was found by professors Eugene Fama and Kenneth French, to outperform due to quantifiable “factors” such as low book to market value misses a new key facet of the modern economy: the shift to the dominance of intellectual capital such as intellectual property and employee knowledge as important drivers of growth in earnings as well as stock prices.
The authors attempt to capture this through observed higher levels of selling general and administrative expenses (SG&A) in companies that tend to perform better over time. They used a previously developed cumulative SG&A model as a proxy for intangible capital investment. Their findings showed outperformance of stocks which had low cumulative SG&A to market price over time relative to a portfolio of stocks with a simple low book to value over time. This additional factor was likely helped in that it may have been able to capture more of the value inherent in some more richly valued tech shares in comparison to traditional value companies. The cumulative outperformance of their hypothetical portfolio (which also shorts the high market value to SG&A stocks) can be seen below.
HMF FF is the traditional Fama French value factor model portfolio while that produced by the authors is labeled HML INT and marked in blue. The conclusion is that this could be a valuable overlooked factor in selecting value stocks. Given the ease with which ETF’s are created these days, don’t be surprised to see an ETF with this new factor taken into account coming onto the market soon.
The Next Decade
Discoveries like these should encourage those investors that feel that there is still some credence to value, whether they are institutional or retail traders. The fact that value is down in the dumps in terms of returns is looking more and more similar to 1999 when the world was fixated on growth but in the long run value was actually the play for the next 10 years. Could the next decade see a new renaissance for stock pickers, value and hedge funds? Only time will tell, but if the future looks anything like the past, it’s looking more and more like a replay than a new paradigm in the market.
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