Archives For Value Investing

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!

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 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

Quiz!

When are stock returns highest on average?

  1. When the world economies are strong, and investment sentiment is positive.
  2. When stock valuations are at an extreme low, reflecting a grim economy.
  3. When stock valuations are high, and uncertainty is high.

Investing in the Midst of a Pandemic

The coronavirus pandemic brings substantial uncertainties. While the instinct is to wait for clarity before investing, the biggest returns tend to come starting at times of greatest uncertainty. This was true in past declines, and the current one is no different. On 3/23/2020, stocks hit a bottom with no clarity on the timeline for the world stopping the spread of the virus, and no clarity on how the world economy would survive social distancing. A moderate reduction of uncertainties led to phenomenal gains in stocks. As additional uncertainties get resolved, there is a chance for additional gains. This article refers to the coronavirus – as always, additional negative and positive surprises may appear, leading for ups and downs, beyond the uncertainties listed below. In addition, investors expect economic pain from the social distancing, and this may be reflected in stock prices too little or too much. Here is the timeline so far and potentially looking forward.

Past:

  1. Around the bottom, central banks and governments announced substantial support for economies, including the Federal Reserve using the term “unlimited support”.
  2. Over time, we saw the number of daily new cases in many countries level off, and in some cases, revert. This gave some comfort that with social distancing, the virus could be contained in a reasonable timeline.

Future:

  1. Additional central bank & government support until the end of the pandemic’s economic impact.
  2. Increased testing, to allow quick isolation of infected people. A lot already happened, but more is needed.
  3. Increased contact tracing, both automated and manual, to isolate people who got in contact with infected people. Automated solutions are being developed. There is currently substantial hiring for contact tracers. My understanding is that a lot more progress is needed on this item. This is a good example of creating reemployment to help with the effort to end the pandemic.
  4. Transition from level and fewer daily new cases, to a worldwide reduction in total cases, so fewer people will be able to spread the disease.
  5. A potential die-off or weakening of the virus, as eventually happens with some viruses.
  6. Treatments to reduce the severity of the disease.
  7. Widespread vaccines.

Key Point: The intuition of many investors is to wait to invest in stocks until uncertainties are removed. This leads them to invest at times with much higher risk of long-lasting declines. If you have enough resources to weather substantial declines that are always a possibility with stock investing, you may be lucky enough to invest at a time that can both help your returns as well as prepare you for future cycles.

Quiz Answer:

When are stock returns highest on average?

  1. When the world economies are strong, and investment sentiment is positive.
  2. When stock valuations are at an extreme low, reflecting a grim economy. [Correct Answer]
  3. When stock valuations are high, and uncertainty is high.

Explanation:

  1. A strong economy with positive sentiment can lead to gains for a long while, but is also reflective of peaks in stocks.
  2. When the economy is in poor shape, and valuations already reached low levels, people already sold a lot. The declines may continue for some time, but eventually a turnaround comes, and some of the strongest stock returns may begin.
  3. High uncertainty along with high stock valuations could sometimes lead to gains and sometimes losses. The high valuations sometimes mean that not enough selling was done to reflect the uncertainty.

See article above for more explanations.

Disclosures Including Backtested Performance Data

Quiz!

Which are good ways to reduce your risk after 10 years of poor returns for a diversified investment? (There may be multiple answers.)

  1. Diversify and include some lower risk investments that performed well in the past 10 years.
  2. Lower your risk by holding some bonds.
  3. Lower your risk by holding some cash.
  4. Don’t make any change.
  5. Increase your allocation to the investment.

5 Rules of Thumb to Avoid Making a Painful Investment Change

Have you ever seen your diversified investments perform poorly for an extended period of 5-10 years, and felt that it would be prudent to diversify to reduce your risks? Have you moved money to an investment that felt much safer based on those years? In most cases, such activity would increase your risk – the opposite of your intended action. In some cases, the results could be painful.

How can a shift to reduce risk end up being painful? Diversified investments tend to be cyclical. The risk of a tough decade following a tough decade is lower than typical, not higher. Furthermore, the risk of a tough decade after an exceptional decade is higher than typical. Here is a case that may be familiar to you: In the late 1990’s US Large Growth stocks seemed like the safest stocks in the world. A switch to these seemingly safe stocks could have led you to losing 30% of your money over the following 10 years (total returns, including dividends, starting 3/1999). If you would have switched away from the seemingly risky Value or Emerging Markets stocks, your pain would have compounded, by missing phenomenal growth.

How can you avoid making a flawed change? Here are a few rules of thumb:

  1. Compare your investment performance in the past 10 years to the long-term performance (ideally 30+ years). If the past 10 years were below average, the investment is likely to be less risky than usual, not more. Don’t make a change!
  2. Do the same for the target investment you want to diversify into. If the past 10 years were above average, the investment is likely to be more risky than usual, not less. Don’t make a change!
  3. Do the same when comparing valuations, as presented by Price/Book. If the change would increase your Price/Book, you would sell low and buy high, something that can hurt you.
  4. Imagine living through a period with the opposite recent performance – would you still feel that you are reducing your risk with the intended change? If not, the alarm bells should be ringing.
  5. Say that someone urges you to diversify your portfolio, given the risk of your current portfolio, as presented by recent performance. Check how diversified your current portfolio is. If it includes 100’s or 1,000’s of stocks, split over many sectors in many countries, you are probably already diversified. The phrase: “You should diversify”, is a disguise for the real intent: “You should buy the recent winners, no matter what it does to your diversification.”

How can you use the information above today?

  1. Just like in the 1990’s, US Large Growth stocks performed far better than their long-term average. They averaged about 13% per year over 10 years, compared to a 10% long-term average. You should realistically expect the returns in the next 10 years to be much lower, not just below 13%, but far below 10%. In addition, the P/B of these stocks is far above average, another warning sign for poor upcoming returns.
  2. The reverse is true for Emerging Markets stocks. They grew far below their average. For example, the portfolio Extended-Term Component grew by a mere 2% per year in the past 10 years, compared to 9.3% 22-year average. In addition, the valuations of this portfolio are far below average. Returns above the 9.3% average in the next 10 years are the likely outcome.

A few words of caution: cycles don’t have a fixed length. Returns that are better or worse than average can continue longer or shorter than expected. In addition, long-term averages can fluctuate. While no result is guaranteed, the information above can help you work with the odds, and not against them.

Quiz Answer:

Which are good ways to reduce your risk after 10 years of poor returns for a diversified investment? (There may be multiple answers.)

  1. Diversify and include some lower risk investments that performed unusually well in the past 10 years.
  2. Lower your risk by holding some bonds.
  3. Lower your risk by holding some cash.
  4. Don’t make any change.
  5. Increase your allocation to the investment. [Correct Answer]

Explanations:

  1. Answers 1-3: Diversified investments tend to be cyclical – selling after 10 tough years, is likely selling low. Buying an investment that performed unusually well at the same time, is likely buying high. This will likely increase your risk.
  2. Answer 4: While future returns are likely to be above average, and risks below average, no change will keep your risk profile at the same reduced level.
  3. Answer 5: Buying extra at a very low point may reduce your risk, if valuations (Price/Book) are far below average and the investment is diversified.

Disclosures Including Backtested Performance Data

Quiz!

Which of the following can make you happy while your investment is low? (There may be multiple answers.)

  1. You hold a company with a strong track record.
  2. You hold a company with market dominance.
  3. You take some risk off, and switch to bonds.
  4. You take some risk off, and switch to cash.
  5. You take some risk off, and switch to a well proven investment that did well over an entire decade.

Can you be Happy with your Volatile Stock Portfolio Whether it is Up or Down?

High investment growth comes with volatility, and is treated as the price for enjoying the high long-term gains. What if you could stay happy even during declines?

Conditions:

  1. When working, live according to your income. Don’t spend beyond what you make.
  2. When retired, spend a small percentage of your portfolio every year. Don’t plan on running out of money in your lifetime. 3%-4% is appropriate for most diversified portfolios with a high enough stock allocation.
  3. Invest in a highly diversified stock portfolio, without any specific bets (specific companies, countries, etc.).
  4. Structure the portfolio for high growth (emphasize stocks, value investing, small stocks, fast growing countries).
  5. Maintain iron discipline to stick with your portfolio for life, and never make changes at low points (unless you move to another investment with at least equally low valuations and equally high long-term returns).

If you follow the conditions above, you can be happy in up and down times, as follows:

  1. By nature, you have a fast growing portfolio in the long run, a cause for underlying happiness.
  2. When you enjoyed high past gains, you can be happy with the past results.
  3. When recent returns have been poor and valuations (price/book) are low, you can be happy about the high expected returns.
  4. If you have any new money to invest (savings from work, inheritance, money elsewhere), you can be very happy, because investing this money at a low point turns a temporary decline into a permanent excess gain (the gains on buying low).
  5. Over the cycles, the dollar value of the percent spending can go up as you reach higher peaks, leading to happiness about growing cash flows.

Most people struggle with such a plan, because the media pushes them to think about parts of the cycle, e.g. 5-10 years. This leads investors to be unhappy during downturns, and sometimes even destroy their life’s savings by selling low and buying something else high. Any high-growth investments can go through downturns of 5-10 or more years (e.g. the S&P 500 lost 30% of its value in the 10 years from 3/1999-2/2009), so it takes strength to stay disciplined. The best tool to maintain discipline is to watch valuations (price/book). After your high-growth investment goes through a long tough stretch, you can compare it to another investment that performed very well in recent years, and you are likely to see that your investment is enjoying substantially lower valuations, leading to substantially higher expected returns in upcoming years. While there is no guarantee for a specific turning point, you enjoy the nice combination of lower risk and higher expected returns.

Quiz Answer:

Which of the following can make you happy while your investment is low? (There may be multiple answers.)

  1. You hold a company with a strong track record.
  2. You hold a company with market dominance.
  3. You take some risk off, and switch to bonds.
  4. You take some risk off, and switch to cash.
  5. You take some risk off, and switch to a well proven investment that did well over an entire decade.

Explanations: None of the answers are correct!

  • 1-2 depend on concentrated investments. History taught us repeatedly that single companies aren’t immune to irreversible downturns.
  • 3-4 may feel good at the moment, but they turn a temporary downturn (assuming your investment is diversified and consistent) into a permanent loss.
  • 5 may also feel good at the moment, but investments are cyclical, and the best performer of the past 10 years is likely to underperform your poor performing investment in the next 10 years. A glance at the relative valuations (price/book) of the investments can confirm this risk.

Disclosures Including Backtested Performance Data

Quiz!

Which of the following are true about US stocks (multiple answers may be correct)?

  1. Value stocks outperformed growth stocks in the past 90 years.
  2. Value stocks have become more expensive than growth stocks.
  3. Growth stocks grow faster than value stocks.

Value Investing Is Alive and More Appealing Than Typical

I’ve seen a number of articles declaring US value investing dead.

What is Value Investing? Value investing refers to buying companies with low stock prices relative to their intrinsic value, or book value (i.e. low Price/Book or P/B). Over the past 90 years, the collective of US value stocks outperformed growth (high Price/Book) stocks.

Why would people question value investing now? US Value stocks have underperformed US Growth (high Price/Book) stocks for the past 10 years – long enough for people to believe that maybe there is a new normal and value stocks will underperform growth stocks moving forward.

What is the theory for the new normal? The theory is that value investing became more commonplace, and the extra investing in value stocks led to bidding up their prices and eliminating the excess-return benefit compared to growth stocks.

Let’s test the theory. If the theory is right, the prices of value stocks increased all the way to match the prices of growth stocks (by definition, they cannot be any higher), eliminating the pricing benefit. It turns out that the opposite is true: the discount in Price/Book of value stocks increased significantly in the past 10 years.

Conclusion. The theory that value investing is dead due to overcrowding fails a simple math test. Based on the test, the opposite seems true, supporting the notion that the underperformance is part of a cycle, and value investing may enjoy greater excess returns than typical in upcoming years.

Implications for other investments. There are 2 other investment categories that show potential promise thanks to a similar simple mathematical test: US Small stocks & Emerging Markets stocks.

Quiz Answer:

Which of the following are true (multiple answers may be correct)?

  1. Value stocks outperformed growth stocks in the past 90 years. [The Correct Answer]
  2. Value stocks have become more expensive than growth stocks.
  3. Growth stocks grow faster than value stocks.

Explanations:

  1. This has been correct in the US for the past 90 years, and in other countries for decades.
  2. The opposite is true: value stocks are enjoying lower valuations (Price/Book, or price relative to the intrinsic value) today than in recent years.
  3. This has been true in the past 10 years in the US, but not in the long run.

Disclosures Including Backtested Performance Data