Quiz!

Can You Make Money Buying Stocks that Declined?

  1. No
  2. Yes, with a combination of a diversified stock portfolio along with very low valuations.
  3. Yes, after a careful analysis of buying near the bottom.
  4. Yes, with diversified stock investments.

Can You Make Money Buying Stocks that Declined?

When you see your stock portfolio decline, is your instinct to double down and invest more, or sell and wait on the sidelines until the sky clears? Knowing whether a recovery at a reasonable timeframe is likely depends on multiple factors. Here are cases that could lead to disappointment:

  1. If your portfolio includes only one or a few stocks, it may never recover. Many companies go bankrupt every year.
  2. If your portfolio reached extremely high valuations, as measured by price relative to book value (or liquidation value), you could make money by holding on until past the recovery, but the recovery could be many years away.

If your portfolio is diversified and has very low valuations, you may enjoy seeing a recovery within a reasonable timeframe, making you money. This is far from guaranteed. Here are steps to increase your chances:

  1. You need a robust risk plan, that accounts for a significant amount of additional declines, with a prolonged timeframe to recovery.
  2. With the right risk plan in place, you need to be 100% committed to your plan. When additional declines occur, you are not likely to see headlines saying “don’t worry, everything will be fine, this is a temporary dip”. The headlines are likely to be between negative and terrifying. Sticking with the plan requires putting all emotions aside, focusing on your risk plan, and following it mechanically – not for the faint of heart!
  3. Buying after declines requires a great deal of humility. You may have strong gut feelings on the “obvious” next move for stocks. Avoid setting any short-term expectations – the next move is mostly influenced by information that is not available at the moment.
  4. Start by having your normal allocation. Then, given the uncertainty, it helps to have a multi-step plan, with incremental small investing with every material additional decline. Allow for more declines than you can imagine. This can empower you knowing that you are proactive with additional declines.
  5. An incremental investing plan is smart in theory, but can be tough to execute. On the way down, you are likely to feel increasingly wrong. Remember that your goal is not to call the bottom – a very tough thing to do, but to emphasize extra investing when the odds are stacked more strongly in your favor, and the risks are lower.
  6. If you don’t have long-term valuation data for your investment, one alternative is comparing the 10-year performance relative to the long run. 10-year outperformance relative to the long run could mean high valuations and high risk.
    1. For example, the S&P 500 had far above average returns in the past 10 years, leading it to reach near record valuations. Buying on the dip beyond your normal allocation in such cases can be very risky.
    2. On the other hand, Emerging Markets Value investments had unusually low returns in the past 10-years, leading to below average valuations. Buying on the dip beyond your normal allocation in such cases may be profitable, subject to all the precautions described above.

Quiz Answer:

Can You Make Money Buying Stocks that Declined?

  1. No
  2. Yes, with a combination of a diversified stock portfolio along with very low valuations. [Correct Answer]
  3. Yes, after a careful analysis of buying near the bottom.
  4. Yes, with diversified stock investments.

Explanations:

  1. While there are no guarantees, with the right plan, you can make money buying stocks that declined – read on.
  2. Diversified stock investments tend to recover after declines. As long as you hold onto the investments until they hit a bottom, fully recovered and reached new peaks, you can make money. The low valuations help avoid some of the longest declines of stocks.
  3. A careful analysis may or may not be successful at identifying the bottom. In addition, a concentrated portfolio of one stock may never recover.
  4. While diversified stock investments tend to recover after declines, if the valuations are extremely high, it may take many years to enjoy a gain.
Disclosures Including Backtested Performance Data

Quiz!

Which is the best diversifier for US tech stocks?

  1. Cash
  2. Bonds
  3. US Value Stocks
  4. Emerging Markets Stocks
  5. Emerging Markets Value Stocks
  6. Bitcoin

A Great Diversifier to Hi-Tech

If you work in hi-tech, your financial position could be greatly influenced by the hi-tech cycle. Your income comes from hi-tech. In addition, If you have any stock options, stock grants or actual stocks of your company, they all depend on hi-tech. Even if you do not work in hi-tech, but most of your clients do, you are very dependent on this sector. When constructing your investment portfolio, it is worth being aware of this. It may be tough to diversify, if you believe that the strong run of hi-tech in recent years will never stop. To understand how a reversal is possible, note that valuations (price/book) of tech stocks surged in the past 10 years. This means that people are paying substantially more (price) for company values (book). This is in contrast to company values (book values) improving as much as the price gains, leading the price/book to stay flat over these years.

You may be discouraged by the fact that interest rates are low and expected to go up, and inflation has spiked. Commonly discussed candidates for moderating the risk of expensive tech stocks, including bonds and cash, can get hurt by rising interest rates and inflation.

There is a solution that doesn’t require accepting the typical low returns of bonds and cash, and without giving up the liquidity of stocks. This solution is especially helpful when interest rates and inflation go up. The solution is Value stocks, especially in other countries. When US tech stocks declined for over 10 years starting in 2000, Emerging Markets Value stocks grew substantially. This occurred at a time of extreme valuations for tech stocks, just like we are experiencing today. So, while any investor should be cautious of a concentration in high-tech stocks today, if your income is tied to hi-tech, you have a good diversifier available now.

Note that diversified Emerging Markets Value funds already have an allocation to high-tech stocks (while emphasizing lower valuations than typical), so they don’t require a separate allocation to high-tech.

Quiz Answer:

Which is the best diversifier for US tech stocks?

  1. Cash
  2. Bonds
  3. US Value Stocks
  4. Emerging Markets Stocks
  5. Emerging Markets Value Stocks [Correct Answer]
  6. Bitcoin

Explanations:

  1. Cash offers zero volatility, and seems perfectly safe. The issue is that it loses money to inflation. With a modest 3% inflation rate, you lose 50% every 24 years.
  2. Bonds offer low volatility, at a price of low returns. While they may seem compelling, they can decline when interest rates go up, and they can lose value relative to inflation.
  3. US Value Stocks are a good diversifier given that they are helped by rising interest rates and inflation, while tech stocks tend to get hurt by those. They are still subject to US-specific country risks, so are not the best.
  4. Emerging Markets Stocks diversify the US-specific country risk, but there is still better!
  5. Emerging Markets Value Stocks diversify the US-specific country risk, and are also typically helped by rising interest rates and inflation, while tech stocks tend to get hurt by those.
  6. Bitcoin is a currency, with no expected positive returns. But, it is far worse than cash, because it is extremely volatile. In addition, people were drawn to it in recent years given the high past returns, similar to tech-stocks. As seen recently, they can experience declines together with tech stocks. This is opposite of what some speculated, thinking that it may be a good inflation hedge.
Disclosures Including Backtested Performance Data

Quiz!

Question 1: In the past 10 years, how much did the S&P 500 companies grow their book values (change in price divided by change in price/book)?

  1. 16.2%
  2. 6%
  3. -6%

Question 2: Last time the S&P 500 had approximately today’s valuations, what was its average annual performance in the following 10 years?

  1. 16.2%
  2. 10%
  3. -1%

S&P 500 10-Year Returns if The Past Repeats

The S&P 500 enjoyed strong returns averaging 16.2% per year in the past 10 years. 10 years look like a long track record, enough to entice investing in the S&P 500 today, based on this data. Let’s evaluate this theory:

1. Actual book-value growth calculated at a mere 6%: What was the growth in the book value of the S&P 500 companies in the past 10 years? We can calculate it as the difference between compounding the 16.2% price increase per year and about 9.6% price/book increase per year (x2.5 going from under 2 to nearly 5), which is 6% per year. It turns out that the past 10 years were not very exciting for the S&P 500 companies.

2. Valuations declined 9.6% per year: From the most recent cycle when valuations reached today’s valuations (year 2000), they declined from about 5 to about 2 in 10 years, which is equal to -9.6% per year.

3. If the past repeats itself, we can get -3.3% annual decline for 10 years = -28% total: If the companies do as well as the past 10 years = 6% per year, and valuations revert to normal as happened last time we reached today’s valuations = -9.6% per year, we get an annual decline of -3.3% per year, and a total decline of -28%.

We don’t know what the future will actually be. But, if you are projecting the past to the future, you should prepare for material declines for the S&P 500 over the next 10 years.

Quiz Answer:

Question 1: In the past 10 years, how much did the S&P 500 companies grow their book values (change in price divided by change in price/book)?

  1. 16.2%
  2. 6% [Correct Answer]
  3. -6%

Question 2: Last time the S&P 500 had approximately today’s valuations, what was its average annual performance in the following 10 years?

  1. 16.2%
  2. 10%
  3. -1% [Correct Answer]

See article for more explanations.

Disclosures Including Backtested Performance Data

Quiz!

What are good reasons to invest in Bitcoin? (There may be multiple answers.)

  1. It is a high-growth investment with low correlation to other investments.
  2. High growth as its adoption grows.
  3. Low transaction costs.
  4. Fast transfers.
  5. Free from government control.

2 Reasons I don’t Invest in Bitcoin

Bitcoin is a digital currency / cryptocurrency with many benefits over traditional currencies. This article doesn’t discuss these great benefits, but instead brings up reasons to not hold bitcoin and many other digital currencies for investment.

  1. Just like any other currency, Bitcoin doesn’t generate any value. There are plenty of investments that do generate value, including stocks (companies) and real estate.
  2. While Bitcoin has benefits over traditional currencies, many countries are working on digital currencies with values tied to their traditional currencies. These currencies will have the benefits of digital currencies with an additional big benefit over Bitcoin: central banks can control the supply of currencies, helping stabilize economies, and preventing recessions such as 2008 from turning into devastating depressions. This could stop Bitcoin from reaching the wide adoption that some people anticipate.

Bitcoin played a big role in learning about digital currencies, and designing digital currencies with values tied to traditional currencies. Yet, as an investment, there is nothing that gives me confidence that it won’t permanently decline by 50%, 90% or 99%, as government backed digital currencies come out.

Quiz Answer:

What are good reasons to invest in Bitcoin? (There may be multiple answers.)

  1. It is a high-growth investment with low correlation to other investments.
  2. High growth as its adoption grows.
  3. Low transaction costs.
  4. Fast transfers.
  5. Free from government control.

None of the answers is correct. Specifically:

  1. Bitcoin has historically been a high-growth investment with low correlation to other investments, but there are good reasons to expect the growth to be reversed into sharp declines, once digital currencies that are tied to traditional currencies come out. Read this month’s article to learn more.
  2. You can expect adoption to dramatically shrink once there are government issued digital currencies, that have additional benefits.
  3. Low transaction costs are a benefit of Bitcoin over traditional currencies, but not over traditional digital currencies.
  4. Same as #3.
  5. Bitcoin is currently free from government control, providing a benefit for certain uses including some illegal activities, but that is not a reason to hold them as an investment.
Disclosures Including Backtested Performance Data

Quiz!

Which of the following is the most promising investment?

  1. A company that is losing money and is priced low reflecting the losses.
  2. A profitable company that is underappreciated and priced low.
  3. A company with phenomenal profitability, that you shop from every day, and can’t live without.

Sales up 27%, Profits up 47%, Stock Down 7%! What Gives?

On 7/29/2021, Amazon reported spectacular Q2 sales growth of 27%. Profits grew even faster, at 47%. Yet, the stock declined 7% after the announcement. This is could be unsettling for investors that chose Amazon, given it’s amazing profitability.

What happened? These growth rates were below prior growth rates and the expectations. Stock prices move in response to changes in the company’s performance – a relative measure, as opposed to the absolute company performance. Once the bar is set very high, gains could be tough to achieve, and declines can be very rapid.

Did we get any warning signs? Yes, glaring ones. It’s P/E (stock price relative to earnings) was 69, and it’s P/B (stock price relative to company value or liquidation value) was 17. These numbers are huge, and reflect a company that is 100%’s better than other companies.

An extra difficulty: Stocks of successful companies sometimes go up far above their intrinsic value. It is partly the result of people choosing a company based on its success or even solely based on recent stock growth, while ignoring the stock price. You can do the same, and do well for some time, as people do in various pyramid schemes, or you can join at the peak and experience steep declines. The peak may come during a phenomenal quarter for the company.

How can you use this information? Whenever analyzing whether to buy a stock, look for companies that are underpriced relative to their performance. These include phenomenal companies that are underappreciated, as well as mediocre companies that are priced too low. If you find a company that you love and believe in, analyze how much of its value is already reflected in the stock price, before investing.

What is the future of Amazon’s stock? This question is outside the scope of this article. There are many positive and negative factors, and it’s not a trivial task to combine them to reach an answer. Here is a sliver of the factors: Will the company manage to revert back to its phenomenal growth of prior quarters, or even beat it? Will enough investors continue to bid up the price because they love the company, or because the stock price went up in recent years? Will competition eat into Amazon’s market share, or will Amazon gain even greater market share? Will interest rates in the US go up, hurting Amazon’s borrowing costs? The full list is very long.

Quiz Answer:

Which of the following is the most promising investment?

  1. A company that is losing money and is priced low reflecting the losses.
  2. A profitable company that is underappreciated and priced low. [Correct Answer]
  3. A company with phenomenal profitability, that you shop from every day, and can’t live without.

Explanations:

  1. If the company is priced appropriately, the next step is to check the odds of a turnaround towards profitability. Trusting a turnaround can be risky, and should be done with caution, based on strong evidence.
  2. The combination of profitability & underpricing is the ideal one. Underpriced profitable companies have the potential for extra returns compared to the average company.
  3. A phenomenally profitable company is a great start. If you can’t live without it, and others feel the same, it’s another positive sign. The missing part is whether the stock price reflects more or less of all these positives.

See article for more explanations.

Disclosures Including Backtested Performance Data

Quiz!

Which of the following investments are the riskiest in the face of high inflation? (There may be multiple answers.)

  1. Growth stocks
  2. Real estate
  3. Certificates of Deposit (CDs)
  4. Bonds
  5. Cash
  6. Value stocks

What is Inflation Risk and How to Invest?

US inflation spiked to 4.2% in the past year (by April), more than double the Fed’s target and the average of the past 10 years. The Producer Price Index (PPI), that measures the cost of production, spiked even faster, by 6.2% over the past year. PPI movements tend to precede inflation (measuring consumer prices), meaning that even higher inflation is likely. There are a number of inflationary forces at play including government stimulus and low interest rates.

What is the risk of inflation? Inflation makes your money worth less, just like an investment decline. Unlike a decline in a diversified stock portfolio that tends to be a temporary event, inflation is a permanent decline. For example, in the 10 years 1973-1982 the purchasing power of Americans declined by 57% due to inflation. Unlike appreciating assets such as stocks, inflation does not enjoy sharp recoveries after steep declines. Add another decade to that period, and the inflation compounded to a 70% decline in the value of savings in those 20 years.

It is easy to forget the damage of inflation to your purchasing power after 10 years of below 2% annual inflation. Given that its damage is irreversible, it’s worth being well prepared. Some assets that may be at risk if inflation persists are:

  1. Bonds with a fixed rate. The prices of these bonds decline as interest rates go up, and the decline is greater the longer the term of the bond.
  2. Growth (high Price/Book) stocks that are valued based on earnings far into the future. This is especially true for the extremely expensive S&P 500 stocks that have valuations a mere 10% below the rare and extreme highs of 2000.

How can you invest with high inflation? To make up for losses to inflation you have to grow your money faster than the rate of inflation.

  1. Stocks (company ownership) tend to be defensive against inflation, since the inflation is made up of prices of products and services that companies sell.
  2. Real estate also tends to be defensive against inflation, since housing costs are part of the inflation calculation.
  3. Value stocks (low Price/Book) tend to do better than growth stocks (high Price/Book) in inflationary periods, because their value doesn’t depend so much on earnings far into the future.

Quiz Answer:

Which of the following investments are the riskiest in the face of high inflation? (There may be multiple answers.)

  1. Growth stocks [Correct Answer]
  2. Real estate
  3. Certificates of Deposit (CDs) [Correct Answer]
  4. Bonds [Correct Answer]
  5. Cash [Correct Answer]
  6. Value stocks

Explanations:

  1. Stocks sell products and services that are part of the inflation calculation, so they can do well on average. But, growth stocks (high Price/Book) are valued based on earnings far into the future. These earnings diminish in value faster with high inflation.
  2. Real estate tends to go up with inflation, since housing costs are part of the inflation calculation.
  3. Certificates of Deposit (CDs) have a fixed payment that becomes less valuable with inflation.
  4. Most bonds have a fixed payment that becomes less valuable with inflation. Floating rate bonds don’t have this issue, but they have very low returns.
  5. Cash declines in value directly with inflation.
  6. Value stocks (low Price/Book) are not dependent on earnings far into the future when the inflation has the opportunity to compound the most. Their products and services are part of the inflation calculation, and become more valuable.
Disclosures Including Backtested Performance Data

Quiz!

Which factors may contribute to value (low Price/Book) outperformance moving forward? (There may be multiple answers.)

  1. A change in sentiment.
  2. Rising bond interest rates.
  3. Expectation for inflation.
  4. Very low valuations.
  5. Very low valuations relative to growth (high Price/Book) stocks.
  6. Economic recovery from the pandemic.
  7. The best option out there.

Tipping Point for Value?

Last year will go into the history books given the pandemic. But another, less noticed, rare thing happened. Growth stocks, those with a high price relative to the company’s book value (P/B), or intrinsic value, went from very expensive to extremely expensive – a level barely second to the late 1990’s. While they’ve become more expensive for a while, there was a big spike in unprofitable small growth stocks. Last time we had a spike even close to this magnitude was around 1999. This is very reassuring for Value stocks, because often a long-lasting trend ends in a big spike in the direction of the trend, followed by a sharp reversal. For value stocks in the US, last time the reversal meant a 50% outperformance in a mere 2 years.

There are a number of logical reasons to see a reversal at this point:

  1. A change in sentiment: The reversal already started a few months ago, long enough for people to take note, and start treating it more like a new trend than noise.
  2. Expectation for inflation: Two forces are leading to an expectation for higher inflation: (1) Dramatic government stimulus; (2) The Fed planning to hold interest rates low until after inflation overshoots the typical target. Bond prices already started declining reflecting this expectation.
  3. Very low valuations relative to growth (high Price/Book) stocks: With the valuations of growth stocks going so much higher relative to value stocks, growth stocks became much more dangerous. People took note and started shifting towards value stocks.
  4. Economic recovery from the pandemic: Value stocks tend to outperform at times of economic recovery.

Note that value stocks outside the US have much lower valuations than US stocks – near record difference, making them even more appealing. As always, there could be surprises, and it is important to structure your financial picture to account for them.

Quiz Answer:

Which factors may contribute to value (low Price/Book) outperformance moving forward? (There may be multiple answers.)

  1. A change in sentiment. [Correct Answer]
  2. Rising bond interest rates. [Correct Answer]
  3. Expectation for inflation. [Correct Answer]
  4. Very low valuations.
  5. Very low valuations relative to growth (high Price/Book) stocks. [Correct Answer]
  6. Economic recovery from the pandemic. [Correct Answer]
  7. The best option out there. [Correct Answer]

Explanations: #4 is only partly correct. In the US value stocks are not low relative to their historic average, though they are very low relative to growth stocks. Outside the US, valuations are clearly low.

See article for more explanations about the correct answers.

Disclosures Including Backtested Performance Data

Quiz!

What typically happens to stocks when interest rates & inflation rise?  (There may be multiple answers.)

  1. Stocks go down.
  2. Stocks go up.
  3. Growth (high P/B) stocks go down.
  4. Growth (high P/B) stocks go up.
  5. Value (low P/B) stocks go down.
  6. Value (low P/B) stocks go up.

Look for the answer below and read this month’s article for a discussion.

What Happens When Interest Rates & Inflation Rise?

Optimism about the pandemic’s direction led to expectation for inflation along with rising interest rates in the past month.  The direct impact of inflation and rising rates is damage to stocks & bonds.  This is especially true for growth (high P/B) stocks that obtain much of their value from earnings far into the future – earnings that are less valuable, the higher the inflation.

Beyond the initial reaction, value and Emerging Markets (EM) investments tend to do very well from conditions like today.  The closest example is the behavior of Extended-Term Component (ET) in 2003.

Extended-Term Component (ET) Behavior with Expectation for Higher Interest Rates and Inflation
6/9/2003 2/26/2021
ET P/B 0.93 1.01 (lower equivalent given the profitability tilt since 2014)
Time since recent low 8 months 11 months
10-year treasury rates Increased fast (2% in 2 months) Increased (1% in 7 months)
Federal rates went up starting 1 year later (6/30/2004) ?
Federal rates went up by 4.25% in 2 years! ?
Dollar High and declining High, and peaked recently
ET gained An additional 449% in 4.5 years ?

Every case is different, and I don’t necessarily expect a repeat gain of 449% in 4.5 years.  This information shows that rising rates have not been bad for your investments historically.

Note that in the example above, growth stocks also did very well, but their valuations were substantially lower than today.  Between the positive forces of the economy and stimulus and the negative impact of extreme valuations, it is tough to predict gains or declines for growth stocks.

While I cannot predict future returns, there are a number of factors that would lead me to optimism for both EM and Value investments in upcoming years.  Here is some logic:

  1. Interest rates reached record lows in recent months, and there are mounting forces for higher interest rates and inflation.  This hurts growth stocks, making value stocks more attractive on a relative basis.
  1. During economic recoveries, cyclical value stocks tend to do especially well.
  1. The dollar is relatively high, and has plenty of room to go down, increasing the value of non-US investments.
  1. An economic recovery from the pandemic would lead to a benefit for stocks in general, especially ones that are not already priced high.  The discount of value stocks relative to growth stocks is still at a real extreme.
  1. Beyond value vs. growth, EM Value stocks are priced extremely low relative to US Value stocks.

While the 2003 example above seems most relevant, a more recent situation of rising rates was 2016-2017, where ET enjoyed a 99% gain in about 2 years, within weeks after the Fed started raising rates.  To emphasize, no specific result is guaranteed, but fear of rising rates hurting EM and Value stocks would not be rooted in past experience.

Quiz Answer:

What typically happens to stocks when interest rates & inflation rise?  (There may be multiple answers.)

  1. Stocks go down.
  2. Stocks go up.  [Correct Answer]
  3. Growth (high P/B) stocks go down.
  4. Growth (high P/B) stocks go up.  [Correct Answer]
  5. Value (low P/B) stocks go down.
  6. Value (low P/B) stocks go up.  [Correct Answer]

Explanations:  In general, stocks tend to go up when interest rates & inflation go up, reflecting an expanding economy.  Value stocks tend to outperform growth stocks, as the higher rates & inflation hurt the value of future earnings.  Note that the valuations of growth stocks are extremely high at this point, so it is tough to project their future.

Disclosures Including Backtested Performance Data

Quiz!

In which ways was 2020 different than other big declines (e.g. 2008 & 2000)? (There may be multiple correct answers.)

  1. It was deeper.
  2. It was shorter.
  3. It was scarier.
  4. It was longer.
  5. The turnaround came before economic improvement.
  6. The government & central bank support were bigger than usual.

The Surprises & The Expected of 2020

The pandemic of 2020 was shocking to investors and humans in general. It involved substantial uncertainty, leading people to predict years of pain for stock investments. While the split between surprises & the expected will vary depending on the reader, below is my split.

Surprises:

  1. While the key actions to contain the pandemic were known early on (looking at some Asian countries), the magnitude of unwillingness to take these actions seriously in other countries was greater than I expected, leading to a much worse result than possible otherwise. While stocks recovered rapidly, they could have bottomed higher, with fewer lives lost on the way.

Expected:

  1. The decline was shorter than typical, because it didn’t come from a position of economic leverage and euphoria.
  2. When panic took hold in March, the Fed repeated its 2008 announcement, being prepared to do whatever it would take to support the economy. Other countries operated similarly.
  3. The turnaround came as soon as the level of uncertainty diminished, far before the economy improved, as typical.
  4. While the economy is still hurting badly, it started the turnaround much earlier than in prior declines, thanks to the cause being a shock and not leverage.
  5. Many people said about this decline that it’s different, and will last much longer than past declines. Fortunately, this prediction failed, as typical when made at past times of uncertainty.

The specifics of every market decline are different, creating a need to prepare for declines of varying lengths & depths, worse than we experienced before. While the specifics vary, there are some truths that follow through the cycles, especially some level of correlation between starting valuations (e.g. Price/Book) of risky assets and the severity of the decline. With the right planning, whether cash set aside or low spending relative to liquid assets, there is no need to label any case as “this time is different”. The more prepared you are, the stronger you can be going through scary times, with discipline to avoid panic selling at the depth of the decline.

Quiz Answer:

In which ways was 2020 different than other big declines (e.g. 2008 & 2000)? (There may be multiple correct answers.)

  1. It was deeper.
  2. It was shorter. [Correct Answer]
  3. It was scarier. [Correct Answer]
  4. It was longer.
  5. The turnaround came before economic improvement.
  6. The government & central bank support were bigger than usual. [Correct Answer]

Explanations:

  1. This decline was shallower than the other two declines.
  2. This decline was dramatically shorter than the other two declines.
  3. While every decline is scary, this was scarier, because we haven’t seen such a widespread pandemic in our lifetimes.
  4. This decline was dramatically shorter than the other two declines.
  5. In most declines, the turnaround comes far ahead of the economic turnaround. It comes from a combination of government & central banks (e.g. the Fed) support along with an expectation for a future turnaround.
  6. Both 2008 and 2020 saw very big government & central bank support, but this year’s support was even bigger.

See article for more explanations.

Disclosures Including Backtested Performance Data

Quiz!

Which of the following are good ways to judge the future of portfolios of value stocks?

  1. Look at their 1 year performance. Strong performance is good news.
  2. Look at their 1 year performance. Strong performance is bad news.
  3. Look at their 10 year performance from all historic cases with valuations similar to today. Strong performance is good news.
  4. Look at their 10 year performance from all historic cases with valuations similar to today. Strong performance is bad news.
  5. Look at their 10 year performance. Strong performance is good news.
  6. Look at their 10 year performance. Strong performance is bad news.

Testing Emerging Markets Value Investments in a Simple Graph

Value stocks are priced low relative to their intrinsic value (low Price/Book, or P/B). Value investing makes logical sense: when buying cheap stocks, you can expect to enjoy higher returns. It is not only logical, but also supported by nearly 100 years of evidence. This is all nice, until you look at the past 10 years and see that value underperformed growth (high Price/Book) for the whole period. This raises the suspicion of a new normal. Maybe the entire group of companies with low prices has something wrong with them, and their value will go down over time, to justify the low price?

There is an easy test to differentiate between bad companies and cheap investments:

  1. Bad companies: The underperformance is explained by underperformance of their book values relative to the rest of the market. This is why Warren Buffett tracks the book values of his companies more than prices.
  2. Cheap investment: A lot of the underperformance of value stocks is explained by a change in their valuations (P/B) relative to the rest of the market.

As an example, here is a comparison of DFA funds, one representing overall Emerging Markets (EM), and the other representing EM Value. The graph divides the valuations (P/B) of EM by EM Value. A high value represents an increase in the price paid for all of EM relative to the price paid for EM Value stocks.

clip_image002

For the year (2020), EM Value underperformed EM by about 11%, while the valuations difference increased by 15%. This means that the value companies, as measured by their book value, did 4% better than the overall market. This supports the thesis that these investments are simply cheaper, and you may reap the benefit as the valuations continue their cycle.

Quiz Answer:

Which of the following are good ways to judge the future of portfolios of value stocks?

  1. Look at their 1 year performance. Strong performance is good news.
  2. Look at their 1 year performance. Strong performance is bad news.
  3. Look at their 10 year performance from all historic cases with valuations similar to today. Strong performance is good news. [Correct Answer]
  4. Look at their 10 year performance from all historic cases with valuations similar to today. Strong performance is bad news.
  5. Look at their 10 year performance. Strong performance is good news.
  6. Look at their 10 year performance. Strong performance is bad news.

Explanations:

  1. You cannot conclude anything positive or negative from a 1 year period.
  2. See #1 above.
  3. The combination of averaging many 10-year stretches with a focus on pricing (valuations) similar to today, gives useful information.
  4. See #3 above.
  5. After a decade of unusually good returns, the risk of a weaker decade goes up, so it is not necessarily a good sign.
  6. After a decade of unusually good returns, the risk of a weaker decade goes up, but it is also not a guarantee for a bad next decade.
Disclosures Including Backtested Performance Data