Archives For Value Investing

Quiz!

As of March 31, 2000, US value stocks had underperformed growth stocks by 5.61% per year for the previous 10 years. How many years did it take for value stocks to make up for these 10 years of underperformance?

  1. We are still waiting
  2. 10 years
  3. 5 years
  4. 3 years
  5. 1 year
  6. Less than 1 year

A Vanishing Value Premium?

By Weston Wellington, Vice President, Dimensional Fund Advisors

Value stocks underperformed growth stocks by a material margin in the US last year. However, the magnitude and duration of the recent negative value premium are not unprecedented. This column reviews a previous period when challenging performance caused many to question the benefits of value investing. The subsequent results serve as a reminder about the importance of discipline.

Measured by the difference between the Russell 1000 Growth and Russell 1000 Value indices, value stocks delivered the weakest relative performance in seven years. Moreover, as of year-end 2015, value stocks returned less than growth stocks over the past one, three, five, 10, and 13 years.

Unsurprisingly, some investors with a value tilt to their portfolios are finding their patience sorely tested. We suspect at least a few will find these results sufficiently discouraging and may contemplate abandoning value stocks entirely.

Total Return for 12 Months Ending December 31, 2015

Russell 1000 Growth Index 5.67%
Russell 1000 Value Index −3.83%
Value minus Growth −9.49%

Before taking such a big step, let’s review a previous period when value strategies underperformed to gain some perspective.

As many growth stocks and technology-related firms soared in value in the mid- to late 1990s, value strategies delivered positive returns but fell far behind in the relative performance race. At year-end 1998, value stocks had underperformed growth stocks over the previous one, three, five, 10, 15, and 20 years. The inception of the Russell indices was January 1979, so all the available data (20 years) from the most widely followed benchmarks indicated superior performance for growth stocks. To some investors, it seemed foolish for money managers to hold “old economy” stocks like Caterpillar (−3.1% total return for 1998) while “new economy” stocks like Yahoo! Inc. appeared to be the wave of the future (743% total return for 1998).

Many value-oriented managers counseled patience, but for them the worst was yet to come. In 1999, growth stocks shone even brighter as value trailed by the largest calendar year margin in the history of the Russell indices—over 25%.

Total Return for 1999

Russell 1000 Growth Index 33.16%
Russell 1000 Value Index 7.36%
Value minus Growth −25.80%

In the first quarter of 2000, growth stocks bolted out of the gate and streaked to a 7% return while value stocks returned only 0.48%. As of March 31, 2000, value stocks had underperformed growth stocks by 5.61% per year for the previous 10 years and by 1.49% per year since the inception of the Russell indices in 1979. A Wall Street Journal article appearing in January profiled a prominent value-oriented fund manager who regularly received angry letters and email messages; his fund shareholders ridiculed him for avoiding technology-related investments. Two months later he was replaced as portfolio manager amidst persistent shareholder redemptions.

With value stocks falling so far behind in the relative performance race, it seemed plausible that value stocks would need a lifetime to catch up, if they ever could.

It took less than a year.

By November 2000, value stocks had delivered modestly higher returns than growth stocks since index inception (21 years, 11 months). By month-end February 2001, value stocks had outperformed growth over the previous one, three, five, 10, and 20 years and since-inception periods.

The reversal was dramatic. Over the period April 2000 to November, value stocks outperformed growth stocks by 26.7% and by 39.7% from April 2000 to February 2001.

This type of result is not confined to the technology boom-and-bust experience of the late 1990s. Although less pronounced, a similar reversal took place following a lengthy period of value stock underperformance ending in December 1991.

We can find similar evidence with other premiums:

  • From January 1995 to December 1999, the annualized size premium was negative by approximately 963 basis points (bps), amounting to a cumulative total return difference of approximately 113%. Within the next 18 months, the entire cumulative difference had been made up.
  • From January 1995 to December 2001, the annualized size premium was positive by approximately 157 bps.

The moral of the story?

Prices are difficult to predict at either the individual security level or the asset class level, and dramatic changes in relative performance can take place in a short period of time.

While there is a sound economic rationale and empirical evidence to support our expectation that value stocks will outperform growth stocks and small caps will outperform large caps over longer periods, we know that value and small caps can underperform over any given period. Results from previous periods reinforce the importance of discipline in pursuing these premiums.

Quiz Answer

As of March 31, 2000, US value stocks had underperformed growth stocks by 5.61% per year for the previous 10 years. How many years did it take for value stocks to make up for these 10 years of underperformance?

  1. We are still waiting
  2. 10 years
  3. 5 years
  4. 3 years
  5. 1 year
  6. Less than 1 year [The Correct Answer]
Disclosures Including Backtested Performance Data

It is well established that value stocks (stocks with low price/book value, or price relative to the company’s liquidation value) earn a higher return than the general market. The effect is very meaningful – at least 2% excess annualized return. It was tested through long time periods, retested through new periods, and retested in many different countries (out of sample testing). It is also logical – if the price is low relative to the value of the company assets, it has room to grow to reach the valuations (P/B) of other companies.

So, why doesn’t everyone focus on owning them? Value stocks tend to be less known and less glamorous. They often have low price relative to their book value as a result of poor recent returns. People like to see that the stock “proved itself” before investing in it. They also like to imitate others’ success. To make matters much worse, value stocks don’t always do better. They can do worse for long stretches of 5+ years. I have seen people think logically about investments, and stick through tough periods. But, as the period gets longer, they lose faith in the long-term success.

A strong example from recent years is Emerging Markets Value. This asset class suffered in multiple ways – both emerging markets and value suffered poor performance for the past 5 years. To add insult to injury, the more known US market had unusually high returns. This led people to think that the US is a better investment and to sell from emerging markets to buy US investments.

US stocks reached high valuations (P/B), and emerging markets reached low valuations (P/B). The relative valuations between the S&P 500 and emerging markets value almost doubled in the past 5 years. Your emerging markets investments would not reach the S&P 500’s P/B, until they approximately triple in value – that is about 200% gain. An observation of the past 30 years of emerging markets value returns (partly simulated), shows how surges emerge from low valuations. Here are distinct 12-month periods with ~100% gains in this timeframe:

Period starting at

12-month return

11/1988

83%

2/1991

100%

9/1998

120%

4/2003

97%

3/2009

117%

These returns occurred approximately every 6 years. The value premium is greatest when having big gains that stem from low valuations. For example, in the recent 2009 surge, emerging markets value outperformed the general emerging markets by more than 20%.

What is the logic for these surges? As explained above, the past selling results in poor performance, leading for more people to sell, and propagates the poor returns. This is a snowball that can go on for a while. As valuations reach very low points, any bit of marginally good news can lead to a surge – whether it is a reduction in interest rates, government spending, or economic results that are not bad enough to justify the very low valuations.

Your strong value tilt means that you buy the unloved companies that people sell. When people are completely desperate and lose all faith in these companies, you buy low, and when the turnaround comes, you reap the greatest benefits – life changing benefits. This focus on value stocks is one big thing you have in common with Warren Buffett, one of the greatest investors of all times.

Disclosures Including Backtested Performance Data