The Science Behind Value Investing


It's easy to get distracted from taking a longer view of stock investing. Financial headlines spotlight recent market twists and turns. Cable television pundits like Jim Cramer, an ex-hedge fund manager, encourage investors to seize on the latest news and trade shares of the hottest companies. The cumulative effect is a sense of urgency driven by what's happening in the moment. 

Investors, though, can take advantage of decades worth of data — not to mention more than 50 years of advances in financial science — for direction and guidance. 

This wealth of evidence reveals many significant investment lessons. One of the most enduring is that relatively inexpensive stocks have outperformed over time. Such a value-styled approach to investing is grounded in research showing that investors are likely to find greater upside — i.e., higher expected returns — by patiently sticking to a disciplined approach of buying stocks at lower valuations. 

So how much better has it proved to resist getting carried away with shorter-term bursts of growth and paying up for hot stocks? There is pervasive historical evidence of value stocks outperforming growth stocks. 

The chart below breaks down domestic equity returns for different parts of the market over the longer haul. During this 50-year period, notice the Fama/French benchmark focused on domestic large-cap value generated more than a full percentage point of annualized return compared to its large-cap growth cousin. Such a performance premium was even greater when value was compared to the blue-chip IFA SP 500 Index. 

At IFA, our portfolio managers also tilt client portfolios to small-cap stocks. Combined with a disciplined approach favoring stocks selling at relatively low price-book ratios, a common measure of value, this strategy over the longer-term has produced a notable return premium. 

Again, such a disciplined value investing strategy isn't done out of some sort of mythological belief system conjured up by 'star' active stock pickers who've generated the most media buzz. Instead, we base our asset allocation decisions on the findings of leading financial academics and professional scholars like Nobel laureates Eugene Fama and Harry Markowitz — those whose research have shaped and scientifically enhanced our application of Modern Portfolio Theory in designing client portfolios. 

Despite longstanding empirical support for value investing, it hasn't always beaten growth. Investors need to understand the random nature of stock prices and the inherent volatility in realized returns. As a result, even though an extended period of 'negative' value premiums might not be expected, such occurrences aren't unusual.

For example, take a four-year stretch that lasted through March 2020. (See chart below.) In that multi-year timeframe, large-cap value and small-cap value U.S. stocks underperformed growth by double-digit percentages. As represented by respective Fama/French style benchmarks, which are compiled using data from the Center for Research in Security Prices (CRSP), even shares of larger companies considered as value stocks slid when compared to the blended IFA SP 500 Index. 

Consider, however, the previous 16 years. During this relatively lengthy period, strategic-minded value investors enjoyed a healthy premium. (See chart below.)

From early 2000 through March 2016, both large- and small-cap value domestic Fama/French stock indexes outperformed cousin growth benchmarks by significant amounts on an annualized basis — 1.26% a year for large value and 7.66% for small value. 

Given that stock returns are unpredictable, there is precedent for the value premium turning on a dime in the other direction — from negative to positive. For instance, the table below shows how the past decade can be considered as producing the most pervasive 10-year period of lagging value premiums since the Great Depression.

In the 1930s, the Fama/French US Large Value Research Index fell behind its large growth cousin by an annualized 6.23%. Meanwhile, the Fama/French index for small-cap value domestic stocks lagged its growth counterpart by 3.57%.

Not until the decade that began in 2010 did such negative premiums show up again for both large- and small-cap value index constituents. In the most recent decade, these benchmarks showed that large-cap value underperformed by slightly more than 4% a year and small-cap value lagged by 1.75% on an annualized basis.

In the spring of 2020, though, premiums started reverting to longer-term averages after U.S. stock markets staged a robust turnaround. As American businesses rebounded from the coronavirus pandemic, patient value investors were once again rewarded. 

By September, the performance premium between value and growth had dramatically reversed course. That swing in fortunes kept gaining traction into 2021, as a  comparison of Russell index data through mid-May revealed that U.S. small value stocks were outperforming large growth by a wide margin. Drilling even deeper, equity investors who tilted their portfolios to smaller companies and value-styled fare did even better during this period. (See table below.)

Looking at the big picture — one that takes into account the most complete set of stock market data available to us — showed from 1928 through 2020 an annualized U.S. value premium of 2.80%. In this 93-year period, domestic value stocks returned 12.39% a year while growth stocks gained 9.59%. This included large- and small-cap stocks as represented by respective benchmarks for each style category. 

The table below documents such a value premium across domestic as well as developed international and emerging markets. It also provides benchmark data for the size premium (small- to large-cap stocks). At the same time, we've included figures for another factor that leading academic and professional researchers have found over the years to be a key driver of market returns — a company's level of profitability. As a result, IFA's portfolio management team favors index funds that screen for stocks with greater relative exposure to this profitability premium.

The main takeaway from such an analysis: While disappointing periods have emerged in value investing, the principle that lower relative valuations lead to higher expected returns hasn't changed. (For more information, see "The Hebner Model: A Framework for How Markets Work.")

Such a foundational understanding of how stock markets work underscores the importance for investors of sticking with their holistic financial plan, even through diffiicult periods, in order to make sure they're fully invested to take advantage of the good times.  

Performance results for actual clients that invested in accordance with the IFA Index Portfolio Models will vary from the backtested performance due to the use of funds for implementation that differ from those in the index data, market conditions, investments cash flows, mutual fund allocations, changing index allocations over time, frequency and precision of rebalancing, not following IFA's advice, retention of previously held securities, tax loss harvesting and glide path strategies, cash balances, lower advisory fees, varying custodian fees, and/or the timing of fee deductions.

This is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product or service. There is no guarantee investment strategies will be successful. Investing involves risks, including possible loss of principal. IFA Index Portfolios are recommended based on time horizon and risk tolerance. Take the IFA Risk Capacity Survey ( to determine which portfolio captures the right mix of stock and bond funds best suited to you. For more information about Index Fund Advisors, Inc, please review our brochure at