Morningstar - Q3 2020 - 58

Investors

Frazzini: Whether this time is different is
very hard to test empirically. It's always possible
that the world changed yesterday in a way
that is completely unpredictable and not related
to past history.

The world is, of course, different and constantly
changing, which makes our job harder, but we
haven't seen any evidence that makes us
reject that basic premise of value investing.
Fundamentals still drive stock returns. What might
have changed is the way you capture and
measure those fundamentals. If intangibles are
a larger part of the earnings-generating
power of a firm today, it means, as Andrew rightly
pointed out, that valuation metrics have to
account for that.

they're less important when looking at two
companies that are in the same line of business.

Mispricing and Risk
Bryan: Prices seem to be more disconnected from

fundamentals today than in the past. Is that primarily
due to the difficulty of measuring those fundamentals, or is it the case that prices are not anchoring
as much to what the true fundamentals are?

Frazzini: Both are possible. I can only test
hypotheses with the data we have. What I don't
have available is what the actual realized
earnings five years from now will be. It's possible
that the very expensive companies will
realize such high earnings, revenue, and cash

[T]he spread in valuation ratios between

cheap and expensive companies has reached
historically high levels ...
Andrea Frazzini

At the same time, if you look at the value
performance over the past few years,
the underperformances have been widespread
across a variety of ways of measuring
value, from basic valuation ratios all the way
to metrics that account for intangibles or metrics
that are unaffected by intangibles. You can
look at valuation metrics, price-based reversals,
or empire-building type of metrics, they all
underperform by a large amount.
The other component is industry adjustments.
At AQR, we don't make industry bets based
on valuation metrics. When we think about
whether a company is cheap or expensive, we
always do that relative to industry peers.
That helps control for a variety of structural
exposures. Intangibles might be important, but

Morningstar Q3 2020

flows to justify prices today. I can't refute that
possibility. But in history, on average, that
has not happened. Valuation ratios tend to revert
to the mean.
Ang: This goes back to the economic fundamentals of why buying value should result in a
long-term-and the emphasis is on long-term-
return. There are two economic rationales
for value. The first is the reward for bearing risk.
We may have short-term cyclical losses, but
over the long run, we're compensated with a value
risk premium.

There's also a behavioral aspect of value.
The behavioral story is that we get taken in by the
high-flying growth stocks. We drive up
those prices and ignore the staid, boring value

companies. I think that's happened for several
years, up until now. Since we ignore them, those
prices tend to be low, but the corresponding
forward-looking expected returns tend to be high.
But during periods of extended value drawdowns-
including today, the late 1990s, the 1980s,
and the 1930s-there is a window of time where
it is possible to generate increasing returns
to scale that benefit some companies tremendously. Today, it's streaming technology,
machine learning, and massive data sets. These
certainly lead to increasing returns to scale,
as did using the Internet to reach consumers in the
1990s, global supply chains and computers
in the 1980s, and mass entertainment in the 1930s.
During these periods, we got both cyclical
reactions and also sentiment changes,
then behavioral reactions. Both contribute to the
existence of a long-run value premium.
Bryan: What about the argument that the behavioral
element is less pronounced today because more people
are trading on value?

Frazzini: Value is an active strategy. For every
dollar every value investor is overweight
a cheap stock, there is someone out there who
must be underweight that stock in the same
dollar amount. The universe of active investors has
to hold the market, by definition. So, valuation
changes in the premium have to do with
not just the amount of people tilting toward
a particular factor, but also how large the other
side is.

Having said that, active investing is a competitive
business. I compete with Andrew, and we
compete with everybody else. Therefore, you might
see returns deteriorating, but that's not
special to value investing. That's true for every
active strategy. It's normal that returns
might not be as good now as they were 40 or
50 years ago.
You can have a risk-based explanation for
value, meaning that cheap stocks are riskier in
some sense, and therefore, you have to be
compensated for holding them. Or a mispricing
behavioral explanation that relies on investors
who either have some biases or tune their
portfolios in a particular systematic way. But

Morningstar - Q3 2020

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