At-a-Glance: Key Takeaways on Value Investing & Market Dynamics
- Persistent Valuation Gap – The price gap between expensive and cheap stocks in U.S. equity markets remains historically wide, despite some contraction in 2022.
- Declining Multiples for Cheap Stocks – From 2014 to 2024, the least expensive segment of the market has seen declining valuations, raising concerns about market efficiency.
- Shift to Passive Investing – Trillions of dollars have moved from actively managed funds to passive strategies, potentially disrupting price discovery and market fundamentals.
- Market Efficiency Concerns – Active managers, facing consistent outflows, struggle to influence price discovery, shifting market dynamics in favor of passive investors.
- Implications for Value Investing – While some question whether value investing is "dead," the structural shift in capital flows suggests that fundamental investing may be facing unprecedented challenges.
It is possible that value investing is genuinely dead, as a few have surmised. To our knowledge the coroner has not yet issued a final report, but the evidence is mounting. In the collection of evidence, we continue to note the valuation chasm between cheap and expensive companies in U.S. equity markets. This phenomenon is not unprecedented, but the current iteration grew gapingly large and seems unusually persistent.
There are many ways to evaluate the valuation relationship between cheap and expensive stocks, within various indices and within specific industries, though every version of the analysis we have conducted or seen suggests very strongly that the ten-year period from 2011 – 2021 was associated with relentlessly elevating multiples assigned to the most expensive segment of the U.S. equity market. Meanwhile, multiples assigned to the least expensive segment of the U.S. equity market seemed to develop rigor mortis. The chart below depicts the historical price-to-earnings1 multiple assigned to the most expensive quartile of the S&P 500, as well as the multiple assigned to the least expensive quartile, with the shaded area depicting the spread between the two. By 2021, cheap versus expensive valuation spreads in the U.S. eventually reached levels not seen in many decades. The chasm shrunk in 2022 but grew again in 2023 and 2024 and remains quite wide by historical standards.
Further, though subtle, it is notable that the chart below also shows that multiples assigned to the least expensive quartile actually declined in the decade from 2014 – 2024. Perhaps not surprisingly, the extensive duration of this episode, defined by cheap stocks becoming cheaper and valuation spreads growing ever-larger, has caused many market participants to ponder whether equity markets are genuinely fundamentally “broken.” At the core, the “broken equity markets” and “death of value” investigations share quite a bit in common.
In the context of this valuation conversation, several potential contributing factors have been cited, including, i) a dramatic shift of assets to passive strategies, ii) the ability of individual investors to organize on the internet, which is a potentially powerful facilitator of what Charles MacKay dubbed The Madness of Crowds, and iii) hyper-low interest rates. We wrote a white paper in 2023 explaining why we don’t believe interest rates offer a legitimate explanation, so won’t belabor that here.
Regarding non-professional investors organizing on the internet, we do have some riveting anecdotes of rebellious, intentionally economically-irrational, coordinated behavior. Still, we simply don’t have enough information to analyze the overall contribution of these collusions to the unusual valuation spreads within equity markets. A significant majority of the U.S. equity market is held outside of any type of regulated funds and lies in the hands of individuals, corporations, and institutions. In our experience, it is very hard to gain insight into the collective activity and motivations of that very large and disparate group of investors.
On the other hand, it does seem eminently reasonable to conclude that the trillions of dollars of capital that have been redeemed from actively managed funds and reallocated to passive strategies in recent years has likely had a significant influence on the U.S. equity market’s price discovery process. Actively managed funds experiencing net outflows, which describes the vast majority, have been compelled to sell securities over time to meet net redemptions. According to Investment Company Institute (“ICI”), only 28% of long-term mutual fund complexes saw positive net flows in 2023. Presumably the securities sold include the highest-conviction investment ideas of the active managers, whereby the selling contributes to the equity market’s price discovery process in a manner completely disconnected from the active portfolio manager’s fundamental view. In other words, price discovery is driven by transactions, not by a fundamental view. The ability of active portfolio managers to drive the price discovery process can be severely stunted if they are grappling with consistent outflows, which constitutes a threat to some of the underlying precepts of market efficiency.
Although correlation does not necessarily mean causality, it is not at all surprising that “cheap” versus “expensive,” and large-cap versus small-cap, valuation spreads standout as particularly large within the U.S. equity market, as compared to non-U.S. markets. The U.S. is, after all, where active to passive portfolio flows have been exceptionally strong. According to the ICI, “from 2014 through 2023, index domestic equity mutual funds and ETFs received $2.5 trillion in net new cash and reinvested dividends, while actively managed domestic equity mutual funds experienced net outflows of $2.6 trillion (including reinvested dividends)”. Flows of capital to actively managed domestic equity ETFs have been positive over that period but are extremely small in the broader context.
To conclude, we find it difficult to imagine that there has not been a material impact on price-discovery as a consequence of shifting a material percentage of the entire U.S. equity market from fundamental investment strategies to passive investment strategies, which ignore the relationships of security prices to corporate fundamentals by mandate. The entire raison d’etre of passive strategies is to rely upon a price discovery process conducted by active equity market participants, who are purported to digest fundamental information rapidly and efficiently. However, it seems there is good reason to be fearful that the collective ability of active managers to drive that process has been stunted by outflows and that the weight of flows into passive strategies has been effectively usurping the price discovery process. And while we tend to agree with industry observers who assert that it is not necessarily problematic for passive strategies to manage more capital than active strategies, we do believe that the process of getting to that point, which has entailed massive capital flows from active funds to passive funds, has likely impacted the price discovery process in a meaningful way.
Part 2: Value Investing: Possum's Revenge (Part 2 of 2)
IMPORTANT INFORMATION
This publication does not constitute an offer or solicitation of any transaction in any securities. Any recommendation contained herein may not be suitable for all investors. Information contained in this publication has been obtained from sources we believe to be reliable, but cannot be guaranteed.
The information in this article represents the opinions of the portfolio manager(s) and is not intended to be a forecast of future events, a guarantee of future results or investment advice. Views expressed are those of the portfolio manager(s) and may differ from those of other portfolio managers or of the firm as a whole. Certain information contained in this letter constitutes “forward-looking statements,” which can be identified by the use of forward-looking terminology such as “may,” “will,” “should,” “expect,” “anticipate,” “project,” “estimate,” “intend,” “continue” or “believe,” or the negatives thereof (such as “may not,” “should not,” “are not expected to,” etc.) or other variations thereon or comparable terminology. Due to various risks and uncertainties, actual events or results or the actual performance of any fund investment may differ materially from those reflected or contemplated in any such forward- looking statement.
Date of first use of portfolio manager commentary: October 15, 2024
1 The price-to-earnings ratio (P/E ratio) is the ratio for valuing a company that measures its current share price relative to its per-share earnings.
2 The S&P 500 Index, or the Standard & Poor's 500 Index, is a market-capitalization-weighted index of the 500 largest publicly-traded companies in the U.S. It is not an exact list of the top 500 U.S. companies by market capitalization because there are other criteria to be included in the index.
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