A Level Economics 92: UK's Financial Sector

Changes in the Structure of the UK Economy:

In recent years, the UK economy has undergone significant changes in its structure. One notable trend is the growing size and influence of the financial sector. The financial sector includes banks, insurance companies, investment firms, and other financial institutions. Some key factors contributing to the growth of the financial sector in the UK include:

1. Global Financial Hub: London, the UK's capital, has established itself as a global financial hub, attracting financial institutions and professionals from around the world. The presence of a well-developed financial infrastructure, including stock exchanges, financial services firms, and regulatory institutions, has further strengthened the UK's financial sector.

2. Financial Services Exports: The UK's financial sector is a significant contributor to the country's export revenue. Financial services, such as banking, insurance, and asset management, are exported to other countries, generating substantial income for the UK economy.

3. Technological Advancements: Technological advancements have facilitated the growth of financial services, such as online banking, digital payments, and fintech innovations, contributing to the expansion of the financial sector.

4. Deregulation and Globalization: Deregulation and increased globalization have allowed financial institutions to operate more freely across borders, expanding their reach and influence.

Asset Bubbles and Economic Consequences: Asset bubbles occur when the prices of certain assets, such as real estate, stocks, or commodities, rise to unsustainable levels, driven by excessive speculation and investor optimism. When the bubble eventually bursts, asset prices collapse, leading to severe economic consequences. Examples of asset bubbles include the dot-com bubble in the late 1990s and the housing bubble that preceded the 2007-2008 financial crisis.

Causes of Asset Bubbles:

1. Easy Credit: Loose monetary policies and low-interest rates can encourage borrowing and speculative investments, driving up asset prices.

2. Speculative Behavior: Investors' expectations of ever-increasing prices can lead to speculative buying, further inflating asset values.

3. Herd Mentality: As more investors rush to buy a particular asset, it can create a herd mentality, pushing prices higher.

Economic Consequences of Asset Bubbles:

1. Wealth Erosion: When asset prices collapse, individuals and institutions holding these assets can experience significant wealth losses.

2. Financial Instability: Bursting asset bubbles can lead to financial instability, impacting banks and financial institutions with exposure to the affected assets.

3. Investment Downturn: Asset bubble bursts may discourage investment and lead to a slowdown in economic activity.

4. Consumer and Business Confidence: Sharp declines in asset prices can erode consumer and business confidence, leading to reduced spending and investment.

The Role and Purpose of Regulation: Financial regulation is crucial for creating financial stability and protecting consumers and investors. Regulation aims to:

1. Ensure Soundness: Regulators set standards to ensure that financial institutions maintain adequate capital, manage risks prudently, and comply with rules to avoid excessive leverage and instability.

2. Prevent Systemic Risks: Regulation addresses systemic risks that could threaten the stability of the entire financial system.

3. Consumer Protection: Regulation safeguards the interests of consumers and investors, ensuring fair treatment and transparency.

4. Maintain Market Integrity: Regulations promote fair competition, prevent market manipulation, and ensure the integrity of financial markets.

Evaluation of the UK's Large Financial Sector: The UK's large financial sector has both benefits and challenges for the real economy:

Benefits:

1. Contribution to GDP: The financial sector contributes significantly to the UK's Gross Domestic Product (GDP) and employment, supporting economic growth.

2. Global Competitiveness: The financial sector's global competitiveness enhances the UK's position as a financial hub, attracting foreign investment and skilled professionals.

Challenges:

1. Vulnerability to Financial Crises: A large financial sector can make the economy more susceptible to financial crises and their repercussions.

2. Income Inequality: The concentration of wealth in the financial sector can exacerbate income inequality in the economy.

3. Overreliance on Finance: An overreliance on the financial sector may divert resources from other sectors of the economy.

In conclusion, the growth of the UK's financial sector has been significant, making London a global financial center. However, the size and influence of the financial sector bring both benefits and challenges, requiring careful regulation to ensure financial stability and balanced economic growth.

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Bitcoin: too good to miss or a bubble ready to burst?

Eva Szalay in The FT

The problem with investing in bitcoin is that it instinctively feels too good to be true. 

The largest cryptocurrency by volume is worth 600 per cent more today than a year ago, soaring from about $7,000 per bitcoin to $54,000 this week, along the way becoming one of the best performing financial assets of 2020. Despite including some extreme price swings, the year-long rally has so far defied fears of a repeat of bitcoin’s spectacular price crash of 2018.

Eye-popping returns are making it difficult for even hardened cryptocurrency sceptics not to consider putting money into bitcoin and many long-term doubters are crumbling. Jamie Dimon, chief of US banking giant JPMorgan, is just one prominent crypto bear who turned bullish in recent years. Recently emerged cheerleaders include Tesla chief Elon Musk and a number of billionaire hedge fund managers who are convinced that as the digital equivalent of gold, bitcoin’s exchange rate against conventional currencies has even further to soar.  

So is bitcoin just a big Ponzi scheme or a genuine investment opportunity? Should retail investors give in to the temptation to pile in? FT Money has spoken to finance professionals inside and outside the cryptomarket and found that opinion remains sharply divided. The recent stellar performance has turned some bears into bulls. But hardcore naysayers warn that a bubble that has grown bigger is still a bubble. 

Even ardent crypto fans are reluctant to wager their life savings on an asset associated with hair-raising levels of volatility. Even among these enthusiasts, many limit their investments to 1-2 per cent of their portfolio. 

Regardless of whether cryptocurrencies turn out to be the digital equivalent of gold in the long run, today they are providing fraudsters with a rich hunting ground.  

Is it really different this time? 

Since the start of January, bitcoin’s value has risen by 85 per cent and in mid-April it hit the latest in a series of record highs at $65,000. Companies that operate in the digital currency sector are attracting a flood of money. In a recent (conventional) stock market flotation, investors valued Coinbase, the cryptocurrency exchange launched less than 10 years ago, at $72bn, putting it equal with BNP Paribas, a French bank with roots stretching back to 1848. 

Young people are in the vanguard of investing. In the UK, millennial and Gen Z investors are more likely to buy cryptocurrencies than equities and more than half (51 per cent) of those surveyed had traded digital currencies, research from broker Charles Schwab shows.  

After a year of spiralling prices, bears warn of the growing risk of a 2018-style collapse. Bitcoin bulls argue that the current rally is different from the 2018 bubble burst, when the price collapsed from above $16,000 to just $3,000. Today, they say, it is driven by demand from professional trading firms and institutional investors whose presence brings stability.  

Not everyone agrees. “It’s not different this time. There are no new eras, despite what the promoters tell you,” says David Rosenberg, a Canadian economist and president of Rosenberg Research. “Asset price bubbles come, bubbles go, but none of them correct by going sideways.” 

In contrast with younger investors, those aged 55 or over remain resolutely on the margins with just 8 per cent of survey respondents in this age group trading digital currencies, the Charles Schwab study found.  

They may be right to do so. Investors globally have lost more than $16bn since 2012 in cryptocurrency-related scams and fraud, according to disclosure platform Xangle. The Financial Conduct Authority, the UK’s financial watchdog, warned this year that investors can lose 100 per cent of their money when punting on cryptocurrencies. It has not sought to block cryptocurrency dealings but has forbidden the sale of derivatives on crypto assets to UK retail customers. 

As crypto markets are unregulated, investors have no one to turn to for help if they fall victim to fraud. Exchanges can turn out to be bogus and their founders disappear. A new coin might turn out to be a tissue of lies. 

“There are a lot of scams and criminal operations that target individuals and it’s very important to recognise that in an unregulated market there is no recourse,” says Ian Taylor, the chief executive of lobby group CryptoUK.  

Another concern for investors is the environmental footprint of cryptocurrencies. The carbon emissions associated with bitcoin equal that of Greece, according to research by Bank of America, because the coins are created or “mined”, in vast computing centres, which burn electricity and generate heat. 

What are the ground rules? 

Crypto specialists say the most important rule for investors is to be prepared to lose all their money. 

On April 13, bitcoin began a sharp decline, its exchange rate shedding 23 per cent in less than two weeks. Marcus Swanepoel, chief executive of Luno, a retail-focused cryptocurrency exchange with 5m-plus customers, says that in some cases they were overstretching themselves. Luno surveyed its clients last year and found that 55 per cent had no other investments.  

“Never spend more money than you can afford to lose,” he says. “It’s very risky, there is no doubt about it.” 

Extreme swings in the exchange rate mean cryptocurrency exposure should be kept at a low proportion of a portfolio, say most mainstream investment analysts. 

“I understand if you want to buy it because you believe the price will go up but make sure it’s a very small portion of your portfolio, maybe 1 or 2 per cent,” says Thanos Papasavvas, founder of research group ABP Invest, who has a 20-year background in asset management. 

Borrowing money to pump up trades with leverage amplifies gains but inflates losses. As there are no official rules, trading platforms allow investors to wager multiples of the money they deposit, inflating the amount at stake by as much as a 100 times.  

“Leverage on a crazy asset class is a recipe for disaster,” says Abhishek Sachdev, a derivatives expert and head of Vedanta Hedging. 

Choosing the right coin is also important. There are hundreds of cryptocurrencies; most are worthless and some are plain scams. Bitcoin is the oldest, most liquid, coin and it is the one that enjoys support due to institutions investing due to its limited supply. 

According to its original computer-based design, only 21m bitcoins will ever exist and 99 per cent of these coins will be mined by 2030. Other cryptocurrencies are not limited in this way and the hundreds of available digital coins all have different characteristics. 

It is also the most expensive per unit but since it can be bought in small increments, there is no requirement to splash out $50,000 or so for a full coin.  

Ethereum is the second most traded cryptocurrency and has benefited from the tailwind of bitcoin’s rally. The technology behind ethereum is also used in a nascent market dubbed decentralised finance, making the coin a relatively safe choice. dogecoin and the likes occupy the riskiest and most illiquid end of the spectrum. 

How do I buy cryptocurrencies and what are the risks? 

In the UK the easiest way to access cryptocurrencies is to buy a portion of bitcoin on an established exchange such as Coinbase. Given that exchanges have suffered outages, been hacked or collapsed, this is the safest approach, though it is more expensive than other exchanges. 

Coinbase typically charges a spread of about 0.50 per cent plus a fee depending on the size of purchase and payment method. 

 Fintech companies such as Revolut also offer a way in for bitcoin buyers, but there is no way to transfer bitcoins from the app elsewhere or into other types of coin. Since they may only sell it back within Revolut, investors only nominally own bitcoin via the app.  

In the US, investors are able to buy shares in diversified cryptocurrency funds such as Grayscale, which can then be bought and sold like other mutual holdings. Institutional investors can also buy into exchange traded products but these are inaccessible for retail investors in the UK. It is possible to buy into products that offer exposure to companies active around blockchain — the public, digital ledger than underlies bitcoin — such as Invesco Elwood Global Blockchain UCITS ETF. These are a bet on technology, however, rather than the cryptocurrency.  

Selling cryptocurrencies also has tax implications. Digital assets count as property for accounting purposes and profits may be subject to capital gains tax. 

Scammers are a growing problem. Some ask investors to send their private keys to their crypto holdings, promising to return with a profit. But once done, there is no way to undo a transfer. 

Lihan Lee, co-founder of Xangle, advises potential investors to check the past records of any crypto investment schemes, while CryptoUK’s Taylor warns of posting about cryptocurrency investment on social media or cold callers promising guaranteed returns.  

“If a stranger walks up to you on the street and says they’ll give you £150 if they can borrow £100, you probably wouldn’t give them the money,” he says. “It’s the same with crypto.”  

Why are institutions getting involved? 

“If it’s on the side of a bus it’s time to buy,” screams an advertisement from Luno in London. 

Many seasoned investors say the ad should say the opposite. If everyone is talking about the same thing, it’s a sure-fire sign that prices have reached unsustainable heights and are about to collapse — as they did in 2018.  

But in the past 12 months companies and institutional investors have cautiously dipped their toes into digital assets. Since central banks around the world responded to the coronavirus pandemic with easy money policies, large asset managers and hedge funds have been looking for ways to protect themselves from a return of inflation and the erosion in value of of some currencies, including the dollar. 

“We’ve seen a step change in institutional interest last year,” says James Butterfill, an investment analyst at digital asset specialist Coinshares. He notes that around $54bn of money is invested across 120 cryptocurrency funds. A year ago, the total figure was $3.5bn across 89 funds.  

“Cryptocurrencies are here to stay,” wrote Christian Nolting, global chief investment officer at Deutsche Bank’s international private bank, in a report.  

Central banks are even exploring the idea of issuing digital alternatives for domestic currencies. To some analysts, central bank digital currencies lend legitimacy to the crypto space, while others believe it is an attempt by central banks to wrest back control of the market. 

“Central banks have always thought that they were key for payments,” says Randy Kroszner, professor of economics at the University of Chicago Booth School of Business. “And now they’ve realised they’re not.” 

But that does not mean that the risks of cryptocurrencies are likely to dissipate any time soon. As the unregulated market bounces through its latest price gyrations, it is a long way off from either stability or security.

The biggest lesson of GameStop

Rana Foroohar in The FT

Much has been written about whether the GameStop trading fiasco is the result of illegal flash mobs or righteous retail investors storming a rigged financial system. Robinhood’s decision to block its retail customers from purchasing the stock while hedge funds continued trading elsewhere has turned the event into a David and Goliath story. 

But that story is predicated on a false idea, which is that markets that have been “democratised” and that people trading on their phones somehow represent a more inclusive capitalism. 

They do not. Markets and democracy are not the same thing, although most politicians — Democrats and Republicans — have acted since the 1980s as if they were. That period was marked by market deregulation, greater central bank intervention to smooth out the business cycle via monetary policy following the end of the Bretton Woods exchange rate system, and the rise of shareholder capitalism. This combined to begin moving the American economy from one in which prosperity was based on secure employment and income growth, to one in which companies and many consumers focused increasingly on ever-rising asset prices as the most important measure of economic health. 

Right now, short-term fiscal stimulus aimed at easing the economic pain from Covid-19 is distorting the picture. But putting that aside, the US economy is at a point where capital gains and distributions from individual retirement accounts make up such a large proportion of personal consumption expenditure that it would be difficult for growth to continue if there were a major correction in asset prices. 

That is one reason why the GameStop story has so unnerved people. It reminds Americans how incredibly dependent we all are on markets that can be very, very volatile. 

The 40-year shift towards what President George W Bush referred to as an “ownership society” came at a time when the nature of the corporation and the compact between business and society was changing, too. The two phenomenon are of course not unrelated. 

The transformation of markets put more short-term pressure on companies, which cut costs by outsourcing, automating, using less union labour and dumping defined benefit pensions for 401k plans, which put responsibility for choosing investments, and the risks of bad outcomes, on individual workers. In 1989, 31 per cent of American families held stock. Today it is nearly half. Now, it seems, we are all day traders. My 14-year-old recently told me I should “buy the dip,” which did nothing to quell my fears that we are in the midst of an epic bubble. 

GameStop is the perfect reflection of all of this. The ultimately unsuccessful effort to squeeze short-sellers by pushing up the share price illustrates the risks of the markets. At the same time, the company itself illustrates how the nature of employment has changed. In a 2015 Brookings paper, University of Michigan sociologist and management professor Jerry Davis tracked the job growth linked to every initial public offering from 2000 to 2014 and found that the single largest creator of organic new employment was, amazingly, GameStop. The then-fast growing retail chain had an army of mostly part-time game enthusiasts who generally made just under $8 an hour. They were “the new face of job creation in America, ” wrote Davis, whose 2009 book Managed by the Markets is a wonderful history of the rise of the “ownership” society. 

I contacted Davis, who is now at Stanford University working on a new book about the changing nature of the corporation, to ask his thoughts about GameStop and the controversy surrounding it. He sums up the big picture about as well as anyone could: “Rescuing an extremely low-wage employer from short-sellers by pumping up its stock is not exactly storming the Bastille.” What’s more, he adds, “Robinhood easing access to stock trading does not democratise the stock market any more than Purdue Pharma democratised opioid addiction. Democracy is about voice, not trading.” 

I hope that politicians and regulators keep this core truth in mind during the coming hearings about GameStop and Robinhood. I fully expect Treasury secretary Janet Yellen will, based on her recent pledge to staff to address long-term inequality. 

While apps and social media have led more people to trade shares, that has not made our system of market-driven capitalism stronger. Our economy is largely based on consumer spending, and that consumption rests on asset price inflation which can now be brewed up by teenagers in their bedrooms. If current employment trends continue, many of the latter will end up working gig economy jobs without a safety net to catch them when their portfolios collapse. 

That is neither sustainable nor supportive of liberal democracy. That is why I applaud Joe Biden’s core economic promise to move the US economy from one that prioritises “wealth” to one that rewards work. 

The details of the GameStop debacle should be parsed and any villains punished. But we must not lose sight of the main lesson: an economy in which individual fortunes are so closely tied to the health of the stock market rather than income growth is fragile. Speculation, no matter how widely shared, isn’t democracy.

The GameStop affair is like tulip mania on steroids

It’s eerily similar to the 17th-century Dutch bubble, but with the self-organising potential of the internet added to the mix writes Dan Davies in The Guardian

  

Towards the end of 1636, there was an outbreak of bubonic plague in the Netherlands. The concept of a lockdown was not really established at the time, but merchant trade slowed to a trickle. Idle young men in the town of Haarlem gathered in taverns, and looked for amusement in one of the few commodities still trading – contracts for the delivery of flower bulbs the following spring. What ensued is often regarded as the first financial bubble in recorded history – the “tulip mania”.

Nearly 400 years later, something similar has happened in the US stock market. This week, the share price of a company called GameStop – an unexceptional retailer that appears to have been surprised and confused by the whole episode – became the battleground between some of the biggest names in finance and a few hundred bored (mostly) bros exchanging messages on the WallStreetBets forum, part of the sprawling discussion site Reddit. 

The rubble is still bouncing in this particular episode, but the broad shape of what’s happened is not unfamiliar. Reasoning that a business model based on selling video game DVDs through shopping malls might not have very bright prospects, several of New York’s finest hedge funds bet against GameStop’s share price. The Reddit crowd appears to have decided that this was unfair and that they should fight back on behalf of gamers. They took the opposite side of the trade and pushed the price up, using derivatives and brokerage credit in surprisingly sophisticated ways to maximise their firepower.

To everyone’s surprise, the crowd won; the hedge funds’ risk management processes kicked in, and they were forced to buy back their negative positions, pushing the price even higher. But the stock exchanges have always frowned on this sort of concerted action, and on the use of leverage to manipulate the market. The sheer volume of orders had also grown well beyond the capacity of the small, fee-free brokerages favoured by the WallStreetBets crowd. Credit lines were pulled, accounts were frozen and the retail crowd were forced to sell; yesterday the price gave back a large proportion of its gains.

To people who know a lot about stock exchange regulation and securities settlement, this outcome was quite inevitable – it’s part of the reason why things like this don’t happen every day. To a lot of American Redditors, though, it was a surprising introduction to the complexity of financial markets, taking place in circumstances almost perfectly designed to convince them that the system is rigged for the benefit of big money.

Corners, bear raids and squeezes, in the industry jargon, have been around for as long as stock markets – in fact, as British hedge fund legend Paul Marshall points out in his book Ten and a Half Lessons From Experience something very similar happened last year at the start of the coronavirus lockdown, centred on a suddenly unemployed sports bookmaker called Dave Portnoy. But the GameStop affair exhibits some surprising new features.

Most importantly, it was a largely self-organising phenomenon. For most of stock market history, orchestrating a pool of people to manipulate markets has been something only the most skilful could achieve. Some of the finest buildings in New York were erected on the proceeds of this rare talent, before it was made illegal. The idea that such a pool could coalesce so quickly and without any obvious sign of a single controlling mind is brand new and ought to worry us a bit. 

And although some of the claims made by contributors to WallStreetBets that they represent the masses aren’t very convincing – although small by hedge fund standards, many of them appear to have five-figure sums to invest – it’s unfamiliar to say the least to see a pool motivated by rage or other emotions as opposed to the straightforward desire to make money. Just as air traffic regulation is based on the assumption that the planes are trying not to crash into one another, financial regulation is based on the assumption that people are trying to make money for themselves, not to destroy it for other people.

When I think about market regulation, I’m always reminded of a saying of Édouard Herriot, the former mayor of Lyon. He said that local government was like an andouillette sausage; it had to stink a little bit of shit, but not too much. Financial markets aren’t video games, they aren’t democratic and small investors aren’t the backbone of capitalism. They’re nasty places with extremely complicated rules, which only work to the extent that the people involved in them trust one another. Speculation is genuinely necessary on a stock market – without it, you could be waiting days for someone to take up your offer when you wanted to buy or sell shares. But it’s a necessary evil, and it needs to be limited. It’s a shame that the Redditors found this out the hard way.

Coronavirus crisis: does value investing still make sense?

The strategy that once worked for Keynes and Buffett has performed badly writes Robin Wigglesworth in The Financial Times

When Joel Greenblatt went to Wharton Business School in the late 1970s, the theory of “efficient markets” was in full bloom, approaching the point of becoming dogma among the financial cognoscenti. To the young student, it all felt bogus. 

Mr Greenblatt had already developed a taste for calculated gambles at the dog racing tracks. Reading the wildly fluctuating stock prices listed in newspapers also made him deeply sceptical of the supposed rationality of markets. One day he stumbled over a Fortune article on stockpicking, and everything suddenly fell into place. 

“A lightbulb went off. It just made sense to me that prices aren’t necessarily correct,” recalls Mr Greenblatt, whose hedge fund Gotham Capital clocked up one of the industry’s greatest ever winning streaks until it was closed to outside investors in 1994. “Buying cheap stocks is great, but buying good companies cheaply is even better. That’s a potent combination.” 

The article became his gateway drug into a school of money management known as “value investing”, which consists of trying to identify good, solid businesses that are trading below their fair value. The piece was written by Benjamin Graham, a financier who in the 1930s first articulated the core principles of value investing and turned it into a phenomenon. 

One of Graham’s protégés was a young money manager called Warren Buffett, who brought the value investing gospel to the masses. But he isn't the only one to play a role in popularising the approach. Since 1996, Mr Greenblatt has taught the same value investing course started by Graham at Columbia Business School nearly a century ago, inculcating generations of aspiring stock jocks with its core principles. 

Mr Greenblatt compares value investing to carefully examining the merits of a house purchase by looking at the foundation, construction quality, rental yields, potential improvements and price comparisons on the street, neighbourhood or other cities. 

“You’d look funny at people who just bought the houses that have gone up the most in price,” he points out. “All investing is value investing, the rest is speculation.” 

However, the faith of many disciples has been sorely tested over the past decade. What constitutes a value stock can be defined in myriad ways, but by almost any measure the approach has suffered an awful stretch of performance since the 2008 financial crisis. 

Many proponents had predicted value investing would regain its lustre once a new bear market beckoned and inevitably hammered the glamorous but pricey technology stocks that dominated the post-2008 bull run. This would make dowdier, cheaper companies more attractive, value investors hoped.  

Instead, value stocks have been pummelled even more than the broader market in the coronavirus-triggered sell-off, agonising supporters of the investment strategy. 

“One more big down leg and I’m dousing my internal organs in Lysol,” Clifford Asness, a hedge fund manager, groused in April. 

Value investing has gone through several bouts of existential angst over the past century, and always comes back strongly. But its poor performance during the coronavirus crisis has only added to the crisis of confidence. The strength and length of the recent woes raises some thorny questions. Why has value lost its mojo and is it gone forever? 

Search for ‘American magic’ 

Berkshire Hathaway’s annual meeting is usually a party. Every year, thousands of fans have flocked to Omaha to lap up the wisdom of Mr Buffett and his partner Charlie Munger, the acerbic, terse sidekick to the conglomerate’s avuncular, loquacious chairman. Last weekend’s gathering was a more downbeat affair. 

A shaggy-haired Mr Buffett sat alone on stage without his usual companion, who was stranded in California. Instead of Mr Munger, Greg Abel, another lieutenant, sat at a table some distance away from Berkshire’s chairman. Rather than the 40,000 people that normally fill the cavernous CHI Health Center for the occasion, he faced nothing but a bunch of video cameras. It was an eerie example of just how much the coronavirus crisis has altered the world, but the “Oracle of Omaha” tried to lift spirits. 

“I was convinced of this in World War II. I was convinced of it during the Cuban missile crisis, 9/11, the financial crisis, that nothing can basically stop America,” he said. “The American magic has always prevailed, and it will do so again.”

Berkshire’s results, however, underscored the scale of the US economy’s woes. The conglomerate — originally a textile manufacturer before Mr Buffett turned it into a vehicle for his wide-ranging investments — slumped to a loss of nearly $50bn in the first three months of the year, as a slight increase in operating profits was swamped by massive hits on its portfolio of stocks. 

A part of those losses will already have been reversed by the recent stock market rally triggered by an extraordinary bout of central bank stimulus, and Mr Buffett’s approach has over the decades evolved significantly from his core roots in value investing. Nonetheless, the worst results in Berkshire’s history underscore just how challenging the environment has been for this approach to picking stocks. After a long golden run that burnished Mr Buffett’s reputation as the greatest investor in history, Berkshire’s stock has now marginally underperformed the S&P 500 over the past year, five years and 10 years. 

But the Nebraskan is not alone. The Russell 3000 Value index — the broadest measure of value stocks in the US — is down more than 20 per cent so far this year, and over the past decade it has only climbed 80 per cent. In contrast, the S&P 500 index is down 9 per cent in 2020, and has returned over 150 per cent over the past 10 years. 

Racier “growth” stocks of faster-expanding companies have returned over 240 per cent over the same period.  

Ben Inker of value-centric investment house GMO describes the experience as like being slowly but repeatedly bashed in the head. “It’s less extreme than in the late 1990s, when every day felt like being hit with a bat,” he says of the dotcom bubble period when value investors suffered. “But this has been a slow drip of pain over a long time. It’s less memorable, but in aggregate the pain has been fairly similar.”

Underrated stocks 

Value investing has a long and rich history, which even predates the formal concept. One of the first successful value investors was arguably the economist John Maynard Keynes. Between 1921 and 1946 he managed the endowment of Cambridge university’s King’s College, and beat the UK stock market by an average of 8 percentage points a year over that period. 

In a 1938 internal memorandum to his investment committee, Keynes attributed his success to the “careful selection of a few investments” according to their “intrinsic value” — a nod to a seminal book on investing published a few years earlier by Graham and his partner David Dodd, called Security Analysis. This tome — along with the subsequent The Intelligent Investor, which Mr Buffett has called “the best book about investing ever written” — are the gospel for value investors to this day. 

There are ways to define a value stock, but it is most simply defined as one that is trading at a low price relative to the value of a company’s assets, the strength of its earnings or steadiness of its cash flows. They are often unfairly undervalued because they are in unfashionable industries and growing at a steadier clip than more glamorous stocks, which — the theory goes — irrational investors overpay for in the hope of supercharged returns. 

Value stocks can go through long fallow periods, most notably in the 1960s — when investors fell in love with the fast-growing, modern companies like Xerox, IBM and Eastman Kodak, dubbed the “Nifty Fifty” — and in the late 1990s dotcom boom. But each time, they have roared back and rewarded investors that kept the faith. 

“The one lesson we’ve learnt over the decades is that one should never give up on value investing. It’s been declared dead before,” says Bob Wyckoff, a managing director of money manager Tweedy Browne. “You go through some uncomfortably long periods where it is not working. But this is almost a precondition for value to work.” 

The belief that periodic bouts of suffering are not only unavoidable but in fact necessary for value to work is entrenched among its adherents. It is therefore a field that tends to attract more than its fair share of iconoclastic contrarians, says Chris Davis of Davis Funds, a third-generation value investor after following in the footsteps of his father Shelby MC Davis and grandfather Shelby Cullom Davis. 

“If you look at the characteristics of value investors they don’t have a lot in common,” he says. “But they all tend to be individualistic in that they aren’t generally the type who have played team sports. They weren’t often president of their sororities or fraternities. And you don’t succeed without a fairly high willingness to appear wrong.” 

But why have they now been so wrong for so long? Most value investors attribute the length of the underperformance to a mix of the changing investment environment and shifts in the fabric of the economy. 

The ascent of more systematic, “quantitative” investing over the past decade — whether a simple exchange-traded fund that just buys cheap stocks, or more sophisticated, algorithmic hedge funds — has weighed on performance by warping normal market dynamics, according to Matthew McLennan of First Eagle Investment Management. This is particularly the case for the financial sector, which generally makes more money when rates are higher. 

The usual price discount enjoyed by value stocks was also unusually small at the end of the financial crisis, setting them up for a poorer performance, according to Mr Inker. Some industries, especially technology, are also becoming oligopolies that ensure extraordinary profit margins and continued growth. Moreover, traditional value measures — such as price-to-book value — are becoming obsolete, he points out. The intellectual property, brands and often dominant market positioning of many of the new technology companies do not show up on a corporate balance sheet in the same way as hard, tangible assets. 

“Accounting has not kept up with how companies actually use their cash,” he says. “If a company spends a lot of money building factories it affects the book value. But if you spend that on intellectual property it doesn’t show up the same way.” 

As a result, GMO and many value-oriented investors have had to adapt their approach, and focus more on alternative metrics and more intangible aspects of its operations. “We want to buy stocks we think are undervalued, but we no longer care whether it looks like a traditional value stock,” Mr Inker says. 

Mr McLennan points out that while the core principles won’t change, value investing has always evolved with the times. “It’s not a cult-like commitment to buying the cheapest decile [of stocks]. We invest business-by-business,” he says. “I don’t know what the alternative is to buying businesses you like, at prices you like.” 

Bargain hunt

Can value investing stage a comeback, as it did in when the dotcom bubble burst in the early 2000s, or the “Nifty Fifty” failed to justify investor optimism and fell to earth in the 1970s? 

There has clearly been a shift in the corporate landscape over the past few decades that could be neutering its historical power as an investing approach. It is telling that the recent stock market rebound has been powered primarily by big US technology companies, despite value investors having confidently predicted for a long time that their approach would shine in the next downturn. Value stocks tend to be in more economically-sensitive industries, and given the likelihood of the biggest global recession since the Depression, their outlook is exceptionally murky, according to an AQR paper published last week.  

“If value investing was like driving my four kids on a long car ride, we’d be very deep into the ‘are we there yet?’ stage of the ride, and value investors are justifiably in a world of pain,” Mr Asness wrote. However, the odds are now “rather dramatically” on the side of value. 

Redemption could be at hand. there has in recent days been a cautious renaissance for value stocks, indicating that coronavirus may yet upend the market trends of the past decade. This stockpicking approach often does well as economies exit a recession and investors hunt for bargains. 

Devotees of value investing certainly remain unshakeable in their faith that past patterns will eventually reassert themselves. Citing a common saying among adherents, Mr Wyckoff argues that “asking whether value is still relevant is like asking whether Shakespeare is still relevant. It’s all about human nature”. 

Mr Greenblatt, who founded Gotham Asset Management in 2008, says that his students will occasionally quiz him on whether value investing is dead, arguing that computers can systematically take advantage of undervaluation far more efficiently than any human stockpicker can. He tells them that human irrationality remains constant, which will always lead to opportunities for those willing to go against the crowd. 

“If you have a disciplined strategy to value companies, and buy companies when they’re below fair value you will still do well,” he says. “The market throws us pitches all the time, as there are so many behavioural biases . . . You can watch 20 pitches go by, but you only need to try to hit a few of them.”