It’s been tough to be a value investor ever since the onset of the financial crisis more than 12 years ago. That doesn’t mean that value investing is broken, as I explained in the June issue of the newsletter. Much of the underperformance has come from widening valuation spreads, where value stocks have gotten cheaper relative to growth. That trend can’t continue indefinitely--it’s more likely that the valuation gap will narrow than widen, as valuations tend to mean revert over the long term.

There are signs that value stocks are poised to snap back (as they have over the past few weeks). They skew toward sectors that have been especially hard hit by the pandemic and are likely to benefit more than most as the economy recovers from the virus.

Investors can be forgiven for not buying into the argument that it’s finally time for value stocks to shine, as there have been false starts before. And while valuations certainly influence long-term returns, they are a terrible timing signal.

Multifactor funds help reduce the risk of value investing and should still benefit from a potential value recovery. However, there is a more hands-on alternative to achieve those objectives: Trend following. With this strategy, you compare the returns of a value and growth ETF, like iShares Russell 1000 Value IWD and iShares Russell 1000 Growth IWF, hold the fund with the higher returns over the previous 12 months for next month and repeat.

This, like all trend-following strategies, is based on the premise that recent performance tends to persist in the short-term. Historically, this has tended to work better than buying and holding value stocks.

I tested this strategy using the Russell 1000 Value and Growth Indexes going back to the end of 1979. From that starting point through October 2020, the trend following approach beat the value and growth indexes by 1.9 and 1.5 percentage points annually, respectively. While it didn’t always work, it beat the market more often than the value index did over one- (64.5% of the time vs 46.6%) and three-year (70.1% vs 46.8%) holding periods. That’s impressive considering this trend-following strategy held value stocks about 45% of the time. 

This strategy isn’t perfect. It tends to miss the early stages of leadership changes between value and growth and tends to be less tax-efficient than a buy-and-hold approach. And on some occasions, it can be whipsawed between the two styles. That said, on average, this strategy required less than one change per year in my simulation.  

The added attention can help reduce the length and magnitude of underperformance when value or growth stocks are out of favor. Currently, the trend following strategy is pointed toward growth.

Best,

Alex