“Why Strategic Value Investing?” is the question in the title of chapter two of "Strategic Value Investing: Practical Techniques of Leading Value Investors."
Authors Stephen Horan, Robert R. Johnson and Thomas Robinson also poked readers with two thoughts about value investing versus growth investing.
First, the chapter begins with a 1992 quote from Warren Buffett (Trades, Portfolio), in which the guru argued that “value” and “growth” are “joined at the hip.” In Buffett’s eyes, growth is always part of valuation.
Second, the lead paragraph teased a comparison between value investing and growth investing, but the authors argued you cannot make comparisons without considering a host of issues that affect these strategies. The most important of these issues is risk.
So in this chapter, they assess the issues and provide a reasoned conclusion on the efficacy of value investing.
Price reversals
In an article in the Journal of Finance in 1985, Werner DeBondt and Richard Thaler showed it might be possible to predict future prices using past price movements. To prove their case, they showed that the 35 stocks that fell the most in the preceding three years would outperform the market by some 20% over the succeeding three-year period. On the flip side, the 35 best-performing stocks would underperform by 5% in the next three years. Between the two strategies was a 25% differential over three years.
But adopting such a strategy would not be easy. The authors wrote, “Even if these kinds of results were achievable moving forward, it would take nerves of steel and a titanium backbone to implement such a contrarian strategy.” Successful value investing demands a strong contrarian discipline.
Long term versus short term
Achieving contrarian results such as those above also demands patience; the authors note that DeBondt and Thaler’s strategy would show little difference after one year, but would make a difference after three. They wrote, “In fact, once you have identified a market inefficiency and taken a position based on it, markets can often become even more inefficient before the wisdom of your analysis is finally brought to light.”
There is, however, more to value investing than simply price reversals based on technical analysis or contrarian beliefs. Value investing, they say, has a stronger affiliation with fundamental analysis than technical analysis (although some value investors use technical signals to find entry and exit points).
Returns
Historically, the overall stock market averaged returns of 11.8% per year between 1926 and 2012. For a reference standard, three-month Treasury bills returned 3.6%, on average, over the same period.
Of course, the stock market averages mask significant ups and downs, up years climbing as much as 56% and down years as declining as much as 44%. Between those two numbers, there is a range of 100%. In that context, the authors provided the following table (value stocks are those in the lowest 30%, growth stocks are those in the upper 30%, leaving the middle 40% for the rest of the market):
Referring to the table, the authors highlighted several key results:
- Value stocks tended to outperform the overall market.
- Large-cap value stocks outperformed the overall market: 14.7% versus 11.8%.
- Value stocks outperformed growth stocks: 14.7% versus 11.2%.
- Small-cap value stocks averaged 18.8% versus 13.9% for small growth stocks.
Whether large-cap or small-cap value stocks, the differentials between them and the overall market and growth stocks is significant and will have a serious impact on capital appreciation over the longer term.
Risk
Of course, no returns should ever be taken in isolation without also considering the degree of risk involved. Risk is usually assessed by the variability in returns and measured by standard deviation (a statistical metric showing how wide the variation has been).
In any given year, a return is expected to fall within one standard deviation roughly two-thirds of the time. For example, if the overall market’s standard deviation is 20.3% and the average return is 11.8%, then the overall market is likely to see a return between -8.5% and 32.1% two-thirds of the time.
As noted above, value stocks tended to outperform growth stocks and the overall market. But they also involve more risk; as the table above shows, the standard deviation for large-cap value stocks was 27.5%, higher than the 20.3% for the overall market and 20.4% for growth stocks. In the short term, at least, large-cap value stocks will fluctuate more than large-cap growth stocks or the overall market.
Risk and return, together
To look at the relationship between risk and returns, use the Sharpe ratio. It compares the average excess return with standard deviation (“excess return” refers to the difference between a risky asset, such as a stock, and a risk-free investment such as three-month Treasury bills).
Between 1926 and 2012, the Sharpe ratio for the overall stock market was about 0.404, while the ratio for large-cap value stocks was higher (more volatile) at 0.405. And that was significantly higher than large-cap growth stocks, which had a ratio of 0.372. With the higher returns for large-cap value stocks in mind, the authors concluded, “On this basis, it seems as if the reward from value investing more than compensates for the added risk.”
They added, “The risk-adjusted performance edge of value investing is even more pronounced among small capitalization stocks.”
Variability and capital accumulation
So far, the authors have worked with “average” returns, but actual returns rarely match the average; as they observed, we should remember the man who drowned crossing a stream with an average depth of six inches.
So, investors cannot simply multiply the average of 11.8% (the overall market return between 1926 and 2012) by the number of years they are in the market. Their returns are less than the average because of an effect called “volatility drag,” which means the more volatile the returns, the less capital will be accumulated.
To understand this, remember that if you lose 50% of your capital one year, you need more than 50% the next year to get back to even. As the authors noted, “So, we need to be just as concerned about variability of return as we are about the average returns themselves.”
The importance of being “normal”
In the table above, there are also references to “skewness.” Returns might not be normal if they are skewed, meaning that returns on either side of the average are not distributed evenly. For example, a distribution of returns has a negative skew if some returns below the average are more extreme than returns above the average. Investors want positive skewness, which they are more likely to find in value stocks than in growth stocks or the overall market.
There is also a second phenomenon involving statistical language: “excess kurtosis.” It refers to the frequency of that are beyond what is expected, i.e., how often the returns appear beyond what would be expected with a normal bell curve.
The authors wrote, “When extremely positive or negative returns are more common than the bell curve would suggest, those returns are said to exhibit excess kurtosis. As a result, the returns are more risky than a limited examination of only standard deviation would suggest. In other words, there is hidden risk that our traditional measure of volatility does not capture. So, we want to be aware of it.”
Bottom line: Returns with positive skewness and lower excess kurtosis are better for capital gains than returns with negative skewness, and the advantage goes to value stocks in both cases.
Correlation
Next, there is the issue of correlation, which refers to how securities behave in relation to other securities in a portfolio. The authors wrote, “Securities that tend to behave differently over time can smooth out our ride without necessarily decreasing our average return. The decrease in volatility can improve our capital accumulation, and our mood, even if the average return is not improved.”
About 80% of the time, large-cap value stocks and large-cap growth stocks tend to move in the same direction. There is even more correlation among small-cap value and growth stocks: 87%. Advantage: value stocks.
Beta
Finally in this chapter, the authors address “beta,” which compares the variability of a security or portfolio with the movement of the overall market. A stock, for example, that moves less than the overall market is considered less risky: It has a lower beta. A stock that moves more than the market in response to some event or circumstance has a higher beta.
Small-cap stocks, unsurprisingly, have higher betas than large-cap stocks and add risk when added to a portfolio. Value stocks generally have higher betas than growth stocks, again unsurprising when we recall that value stocks come from the bottom 30%. Still, the authors reported that this additional risk from value stocks tends to be “more than compensated in the market place.”
Conclusion
The authors concluded the chapter with these words—and an answer to the question: “Why Strategic Value Investing?”
“There is no single definition of value. Nor is there any single type of value investing. However, most value investing shares some common characteristics. It tends to be rewarded in the marketplace even before we become “strategic” about our security selection. True, volatility tends to be higher and there tend to be more extreme events than even the volatility associated with the normal bell curve would suggest. However, value investing’s higher average returns and less negatively skewed distributions overcome these shortcomings. Value investing works.”
Read more here:
- Â Strategic Value Investing: A Thoughtful Approach
- Higher Returns From Safe Investments: Preferred StocksÂ
- Higher Returns From Safe Investments: The Safest SecuritiesÂ
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