Archives For Value Investing

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

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