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Deep

Pop quiz: Name the giant store whose customers scoff at whatever goes on sale, but flock to buy whatever costs the most.

It isn’t a supermarket. It’s the stock market—especially over the past decade, when value stocks have moldered in the bargain bin. Such companies, trading at low prices relative to their earnings, net assets or other measures, have underperformed pricier growth stocks by one of the longest and widest margins on record.

Is value investing dead?

No.

When will it recover?

No one can say for certain. But when it does bounce back the gains are likely to make the wait worthwhile.

Mind you, value investors have turned blue in the face predicting the revival of cheap stocks. They’ve been wrong for years; they might still be wrong. But I don’t think they’ll be wrong for long.

Consider some evidence gathered by Rob Arnott and his colleagues in a new study. Mr. Arnott is chairman of Research Affiliates LLC, a firm based in Newport Beach, Calif., that pioneered alternatives to traditional index funds. Its investment strategies are used to manage about $190 billion world-wide.

The researchers sought to determine why value has lagged growth for so long, how unusual that is and what might happen next.

Most of the hottest growth companies over the past decade -- Facebook Inc., Amazon.comInc., Netflix Inc., Microsoft Corp., MSFT -0.46% Apple Inc. AAPL 0.23% and Google’s parent Alphabet Inc. —are still in fashion. Over the past year, Apple has returned 108%, Microsoft 60% and Facebook 53%, dwarfing the performance of value stocks.

Cheap Stocks Win...EventuallyOver the long run, value stocks have earnedbetter returns than pricier growth stocks. Inthe past decade, however, cheap stocks haveunderperformed as expensive stocks keepgetting more costly.Cumulative outperformance of value stocksover growth stocks
.pct. pts.513 pct. pts.1970’80’902000’10’2002004006008001,000

Cumulative change in price-to-book ratioSource: Research AffiliatesNote: Figures through 3Q 2019
%Growth stocks: 108%Growth stocksValue stocks1970’80’902000’10’20-100-50050100150

Why have cheap stocks fallen so far behind? The short answer: Investors, already enthusiastic over high-priced growth shares, have turned euphoric, driving their prices even higher relative to value stocks.

Growth companies, argues the Research Affiliates study, haven’t become permanently more profitable. So value stocks should eventually outperform simply because their shares are cheaper.

“People always pay more for growth than for value,” says Mr. Arnott. “But when they get too carried away” on growth stocks, “then higher past returns will presage lower future returns.”

The study finds that value companies aren’t unusually inexpensive relative to their own earnings and assets—but they are nearly the cheapest they’ve ever been compared with growth companies.

That’s true even after adjusting for patents, research and development, and other assets that aren’t fully captured by book value, a traditional measure of net worth.

Financial logic says cheap stocks should ultimately earn higher returns than expensive ones; the less you pay for a piece of the future, the more you will earn in the end. Emotional logic, however, says investors will often overpay for excitement.

Therefore, you should always be prepared for value to lag growth in the short run, even though cheap stocks have earned higher returns over the full sweep of decades. And “the short run” can mean many years.

SHARE YOUR THOUGHTS

How long have you been waiting for your value stocks to outperform? Join the conversation below.

This isn’t the first time value has underperformed growth for at least 10 years, says Savina Rizova, head of research at Austin, Texas-based Dimensional Fund Advisors LP, which manages about $610 billion.

Value trailed in 10-year spans ending in the late 1930s, the late 1990s and every year after 2010—about 15% of the total periods.

Over the ensuing decade after such poor returns, value tended to bounce back sharply, beating growth by an average of more than 8 percentage points a year.

After lagging by 3 percentage points annually over the 10 years ending in 1998, for example, value stocks outperformed growth by more than six points annually over the next 10 years.

History is punctuated with periods when investors made more money buying expensive stocks than cheap ones—for a while, anyway.

Radio Corp. of America’s shares rose tenfold from 1925 through 1929, trading at their peak for a feverish 73 times earnings and roughly 16 times book value. By 1932, RCA had fallen 97% from its 1929 summit.

In the early 1970s, investors imagined that a group of top-performing growth stocks called the “Nifty Fifty” would go up indefinitely, despite already lofty prices; even 30 years later, many of them still hadn’t regained their 1972 highs.

In the late 1990s, no price seemed too high to pay for such leading internet companies as At Home Corp., CMGI Inc., GoTo.com, Lycos Inc. and theglobe.com. Between 2000 and 2002 many dot-com shares fell 90% or more.

Of course, today’s hottest growth stocks might not repeat the collapses of the past. They could be made of sterner stuff. But they don’t need to crash for value stocks to outperform. Investors need only decide to pay somewhat less for the hottest stocks.

“When value gets this cheap [relative to growth],” says Mr. Arnott, “the odds of it succeeding in the future go up drastically.”

It can hurt to sit on your hands while growth investors are clapping theirs to celebrate big gains on expensive stocks that keep getting more expensive. But, sooner or later, value investors will be getting the applause.

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