Rekenthaler Report

4 Questions (and Answers) About Value Investing

By John Rekenthaler | 06-13-14 | 09:00 AM | Email Article
Things Change
Robert Huebscher of Advisor Perspectives, an online publication with many fine
(and free!) articles, recently posed four questions about value investing. He offered
his own answers, which are sound and which I recommend that you read, but he
also wondered about my thoughts. Here goes.
Is there an economic reason why small-company and value stocks have
performed well historically?
(For clarification: The tactic of investing according to a single characteristic, such
as the company being small or its shares trading at relatively low price multiples
(that is, value stocks), has many names. The approach may be called purchasing
anomalies, factors, or risk factors. Recently, it has been dubbed smart beta. As that
reeks of smart marketing, Morningstar prefers instead the term strategic beta.
Anomalies, factors, risk factors, smart beta, strategic beta ... different ways of
saying the same thing.)
Actually, there is some question whether small-company stocks really do all that
well. The "small-company effect" was the first academically documented anomaly,
as Rolf Banzs 1981 paper predated the initial academic research on value
investing, and was once widely believed. It stands to reason that smaller
companies are riskier businesses than are larger firms, and thus deliver higher
returns. But performance over the past 35 years has been disappointing,
particularly when the theoretical gains are adjusted for the hard reality of
transaction costs.
To the extent that smaller companies do outperform, those gains likely owe to a
liquidity premium. Smaller-company shares have lower trading volume, which
increases the chance of moving the stock price by putting in a trade order, and
which hampers the investors ability to rapidly enter or exit a position. Low
liquidity is a real cost that deserves to be compensated with a real return. This is
fine--but properly speaking, its not a small-company effect.
As for value investing, yes, I do think there is an economic reason why they have
performed well historically. By many risk measures, value stocks appear to be less
volatile than growth stocks, but it is also true that when stock markets suffer
traumatic, once-in-a-generation losses, the drawdown on value stocks is higher
than the drawdown on growth stocks. As these market meltdowns tend to occur
when the economy is plummeting, value stocks struggle the most at the worst
possible time. That, too, is a risk that deserves compensation.
I dont think that risk is anywhere near the size of value investings historic
premium, though.
Has the value premium dissipated over time?
Happily--as I did not have the data immediately at hand--Huebscher answers his
own question. He cites Ken Frenchs research as showing that value stocks
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outperformed by 4.57% annually before 1992, and by 2.78% annually since.
The surprise is not that the advantage declined, but that it continued to exist at all.
After all, the market risk associated with value stocks appears only rarely. In
addition, that danger is moderate rather than severe because the alternative to
value investing, growth stocks, also gets whacked by a market crash. Yes, growth
stocks figure to lose somewhat less under such circumstances, but smacking into
the pavement after a 35-foot fall, rather than one of 40 feet, offers scant
consolation.
Does the persistence of the value premium rely on a large group of
investors behaving stupidly?
Its good to win a Nobel Prize.
Many claim that the value premium owes to behavioral reasons. People focus
heavily on recent events, a bias that leads them to overestimate the prospects of
currently strong growth companies and to underestimate the futures of currently
downtrodden, value-priced firms. They are overly influenced by dramatic examples
when calculating an events probability; say "growth stock," and they tend to think
"Apple (AAPL)." Also, value stocks can be embarrassing. Who wants to be known
for owning Eastman Kodak until the bitter end? The '70s came and went, pal.
If you and I were to flatly dispute these arguments, without addressing the details,
we would be naive. If Nobel Memorial Prize-winner William Sharpe does that, he is
profound. Professor Sharpe maintains, to use Huebschers paraphrase,
that "smart-beta proponents assume that, if they are 'smart' to invest in securities
such as small-cap and value stocks, then there must dumb investors who hold the
market portfolio and others who are "really dumb" and underweight those
securities. Therefore, according to Sharpe, smart-beta strategies rely on exploiting
the stupidity of others."
You know what? That is profound. The argument for the value-stock premium
assumes that people collectively are brilliant at forecasting individual-company
prospects, so that few investors can successfully beat the market by selecting one
company over another, without regard to investment style--yet they are
bone-dead stupid in pricing growth versus value stocks, year after year, decade
after decade. And they neither realize their stupidity nor address it.
That said, behavioral biases are notoriously difficult to erase. They tend to occur
subconsciously and require much discipline to overcome. It is not as easy to
become unstupid as Professor Sharpe's argument would suggest. After the first
widespread publication of its existence, the value premium declined by 170 basis
points per year--but it did not disappear. It's one thing to wound the beast, quite
another to slay it.
Are there reasons to expect the premium to dissipate in the future?
Yes. That process is already under way.
News of the value-stock premium has spread so widely that I can write this
column, on a free and (relatively) mass-market website, with the expectation that
most readers will immediately understand the context. Dimensional Fund Advisors,
dedicated to the proposition of being on the smart side of the smart-stupid bet, has
ballooned to become one of 10 largest fund companies. Rob Arnotts Research
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Affiliates, founded just over a decade ago, now runs $170 billion of
"fundamentally" invested assets that look and act much like value stocks.
Its possible that the current enthusiasm for value stocks has temporarily made
them overappreciated rather than underappreciated, and that growth stocks will be
the better bet over the next decade. Even if things have not gone that far, value
stocks are scarcely the sure thing that they appear to be via the rearview mirror.
Those who truly don't care about tracking error and who have a time horizon that
extends for decades might wish to heavily favor value stocks. Most investors,
however, should not tilt more than modestly in that direction.
John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for
Morningstar.com and a member of Morningstar's investment research department. John is quick
to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his
views are his own.
John Rekenthaler is Vice President of Research for Morningstar.
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