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The global stock market is often volatile. If your entire investment portfolio lost 10% of its value in a month during a market decline, what would you do?
- sell all your investments
- sell some
- keep all
- buy more
Value investing is probably the most publicized anomaly, or factor in stock market investing. Globally, value screens are frequently touted as the best strategy for equity investing. Whether value screens have historically outperformed is not in doubt. But the reason for that outperformance has been a hotly debated topic.
Eugene Fama and Ken French argued that value strategies are riskier in many of their published papers (some mentioned in the prior chapter). In their classic paper published in 1992 they analyzed nearly all the stocks on the NYSE, AMEX and NASDAQ from 1963-1990 and segmented them in deciles based on price to book value (high price to book is growth and low price to book is value). The lowest book/market stocks outperformed the highest book/market stocks 21.4% to 8% with each decile performing worse than the previous.1
Many believe that "value" represents a risk factor that investors are compensated for (just as investors expect higher returns from stocks as opposed to bonds). The argument is that value stocks are risky because they are down-and-out and in danger of getting worse, therefore investors need to be compensated with higher returns in exchange for accepting the risk of investing in value stocks.
Many others disagree on the reason for the outperformance of value stocks. Josef Lakonishok, Robert Vishny, and Andrei Shleifer concluded that "value strategies yield higher returns because these strategies exploit the mistakes of the typical investor and not because these strategies are fundamentally riskier."2 Vishny was quoted in Institutional Investor in January 1997 arguing that you “don't make money by investing in a good company . . . You make money by investing in a company that is better than the market thinks." Meir Statman summarized the behavioral perspective. "There are enough papers now that show risk is not what underlies outperformance . . . It is emotion; it is sentiment."3
James Davis, along with Fama and French later verified the value outperformance in the out of sample period from 1929 to 1963 in a paper published in 2000.4 Davis wrote in 2001 "The issue of whether the value and size premiums are caused by risk or inefficiency may never be resolved to everyone's satisfaction. Feelings run strong on both sides of the argument."5
Louis Chan and Josef Lakonishok reviewed and updated the literature regarding the performance of value versus growth strategies through 2001. They concluded that common measures of risk do not support the argument that the return differential is a result of the higher riskiness of value stocks, but rather, in their opinion, it was due to behavioral considerations and the agency costs of delegated investment management.6 Some researchers have argued that the greater risk of value investing comes with greater exposure to macroeconomic risks.7
In the 1990s Fama and French had also documented value stocks outperforming growth stocks over multiple decades in twelve of thirteen major markets. But many others had also studied and documented value stocks’ outperformance internationally. The implication is that investors worldwide (not only Americans) have systematically mispriced value stocks.8
Michael Keppler studied the performance of 18 country indexes from 1969 through 1989. The indexes were grouped into quartiles based on dividend yield and adjusted quarterly. In both local currencies and dollars, the most profitable strategy would have been to own the highest yielding quartile of indexes.9 John Chisolm studied stocks in France, Germany, Japan and the United Kingdom from 1974 through 1989. Stocks were divided into quintiles based on price to book value and adjusted annually. In each country the low price to book value quintile outperformed. The difference in annual compound returns in France and Japan was more than 10% for the period studied. Chisolm also divided stocks into quintiles and found similar results with low price to earnings stocks outperforming, particular in the United Kingdom.10 Carlo Capaul, Ian Rowley, and William Sharpe studied six countries from January 1981 through June 1992 and found that Value Stocks outperformed growth stocks on average in each country.11 Lewis Sanders also studied six countries from 1980 through 1993 and also found that value outperformed the benchmark in each country.12 Researchers also came to similar conclusions regarding Korean stocks. From 1982 through 1993, book-market and sales-price ratios were positively related to performance.13
Many money managers were also arriving at similar conclusions, including David Dreman who discussed his study of the largest 1500 stocks on Compustat for the 25 years ended 1994 in a May 6, 1996 column in Forbes titled "Ben Graham was right—again." He found that the 20% lowest price to book value stocks (quarterly adjustments) significantly outperformed the market which outperformed the 20% highest price to book value stocks.
There are many criteria that fall within the value classification in addition to the price to book metric. Many studies have concluded that stocks with low price to sales, low price to earnings, and high dividends outperform. So called “neglected stocks” are commonly selected by those that follow a contrarian strategy of buying stocks that are out of favor. Werner DeBondt and Richard Thaler conducted a study of the 35 best and worst performing stocks on the New York Stock Exchange (NYSE) from 1932 through 1977. They studied the best and worst performers over the preceding five and three year periods. They found that the best performers over the previous period subsequently underperformed, while the poor performers from the prior period produced significantly greater returns than the NYSE index.14
An interesting debate regarding value investing evolved from T. J. Peters and R.H. Waterman's "In Search Of Excellence: Lessons from America's Best-Run Corporations" (1982). They formed a list of "Excellent" companies based on a number of factors including asset growth, book value growth, and return on assets. Following up on their work, Michelle Clayman studied the performance of the "excellent" firms and another group she termed "unexcellent" (by going "in search of disaster") and found that the characteristics of the excellent companies quickly reverted to the mean in the years following their excellent performance. The unexcellent companies also reverted to the mean and showed substantial improvement. The stocks of the unexcellent firms significantly outperformed the excellent companies over the years that followed.15
More recently Cliff Asness, Tobias Moskowitz, and Lasse Heje Pedersen concluded that "value and momentum ubiquitously generate abnormal returns for individual stocks within several countries, across country equity indices, government bonds, currencies, and commodities." They found that in the U.S., Europe, and Japan, value and momentum (see Chapter 23 for more on momentum) work in combination even better than either factor alone.16
One study that followed up on the question of whether the value anomaly worked after transactions costs found that after adjusting for 1 percent transaction costs and annual rebalancing, investors would have outperformed the market by 4.8 percent over the 1963-1988 period, if they had invested in securities from firms with high book to price and small size. They concluded that the optimal rebalancing period was two years.17
Todd Houge and Tim Loughran were skeptical in a 2006 paper. They concluded "We propose that the value premium is simply beyond the reach of investors ...The bid-ask spread, transaction costs, and the price impact of trading likely work against capture of the value premium in small-cap stocks. Hence, investors should harbor no illusion that pursuit of a value style will generate superior long-run performance.”18
Graham and Doddsville and Coin Flipping
Long before academics were able to prove value criteria outperformed growth, there were, of course, plenty of individuals that argued on favor of value investing. Warren Buffet introduced a coin-flipping contest analogy in 1984 in the Appendix of a special edition of The Intelligent Investor titled "The Superinvestors of Graham-and-Doddsville" (which was from a transcript of a talk given by Buffett at Columbia University).
Buffett suggested imagining all the people in the United States are asked to wager one dollar on their ability to call the flip of a coin. "If they call correctly, they win a dollar from those who called wrong." After each flip the losers drop out, and on the subsequent flip the stakes multiply. Each person has a 50-50 chance of calling each flip and approximately half of the people will lose and drop out each round.
Let’s use recent U.S. and World populations (around 320 million and 7.6 billion) to play out a more current hypothetical scenario. After ten coin flips there would be approximately 312,000 Americans and 7.4 million globally with over $1,000 at that point. After 20 flips, based purely on chance, there would be approximately 300 Americans and over 7,000 people globally with over $1,000,000 in winnings after having called 20 consecutive coin flips. Press coverage and inquiries about their coin calling ability would increase with each successive flip. Several callers might even attempt to profit from their good fortune by writing books on coin calling, setting up phone in services, or by sending mass mailings.
As with winners of the lottery, it’s obvious that those remaining would have been blessed with good luck. But, what if a large percentage of remaining coin flippers had a common characteristic or trait? What if a disproportionate number had come from one town or had been educated by one "patriarch." Would this signify that more than luck was involved in calling coin flips?
It is at this point when it is intriguing to compare the coin flippers to investors. There are literally millions of investors and stock pickers trying to beat the stock market. Clearly, based on the laws of probability, many will be successful in significantly outperforming the market even over long periods of time. The question is: are successful stock pickers effectively equivalent to lucky coin flippers or are there some common characteristics, styles or traits among the outperformers that signify that more than just luck is involved? It is in this context that Buffett introduced the fictional land of Graham-and-Doddsville.
"I submit to you that there are ways of defining an origin other that geography. In addition to geographic origins, there can be what I call an intellectual origin. I think you will find that a disproportionate number of successful coin-flippers in the investment world came from a very small intellectual village that could be called Graham-and-Doddsville."
“When you look at the performance records of successful long term investors it seems that a disproportionate number have a particular investing style. They list value investing as their style and Ben Graham as their ‘intellectual patriarch.’” Buffett went on to identify a number of successful long term investors that all made use of the principles and themes taught by Graham and Dodd. Buffett concluded that the evidence implied that the concentration of winners cannot be explained by chance but "can be traced to this particular intellectual village."
The coin-flipping analogy is a common one and useful for many purposes. An important point to realize is that strong performance doesn't necessarily signify skill, especially in the short term. To differentiate skill from luck it is critical to look at the big picture and the coin-flipping analogy can be useful in that perspective. If the experiment continued, odds are only one American survivor would remain after 28 flips (33 for the world). Similarly, in every ranking and comparison of investors and money managers there has to be someone at the top of the list. The important issue to address is whether there are any common characteristics among the successful coin flippers (or investors) that result in more success than would be expected by pure chance.
There are thousands of money managers, mutual funds, and other market "players" constantly trying to beat the market. Investors who ignore the odds and mathematical probabilities run the risk of investing based on previous successes that are the result of nothing more than random chance. In fact, when researchers compare the distribution of returns of stock pickers (money managers, mutual funds, etc.) with distributions generated at random, they find that the results are hard to differentiate.
It's clear that in the past, a larger percentage of investors from Graham-and-Doddsville have beaten the market than can be explained by chance. But it’s also clear that while Graham-and-Doddsville was once a neglected and little known village, it is now quite popular and a larger percentage of investors classify themselves as natives of the town. Will the village of Graham-and-Doddsville continue to produce a disproportionate number of successful investors in the future? Time will tell, but we know that betting against the villagers certainly hasn't been a market beating strategy in the past.
Robert Huebscher at Advisor Perspectives pointed out in 2015 that 21% of mutual funds and ETFs had the word “value” in their name, versus 14% 20 years earlier. Total assets under management in funds with “value” in their name increased from about 7.5% of all assets to about 11.5%, more than a 50 percent increase.19
ETF providers, custodians, and Robo-Advisors now offer value leaning and other factor based securities and funds with generally lower costs than traditional funds and advisors, but the separate question is whether the popularity of the value and other factor styles will weaken future performance. Near the end of 2018 there were estimates that value style mutual funds and ETFs held close to $2 trillion, with value funds having inflows over the prior decade, while growth funds had outflows of several times as much.20
Some have even suggested that value has not outperformed growth in recent decades and shouldn’t be expected to since the value anomaly was documented. Others argue that formulaic value metrics are potentially too simplistic and potentially at risk to companies that temporarily inflate their accounting numbers.21 Some even argue value investing has been for the most part unprofitable for the last 30 years,22 while others have suggested value's underperformance over the last decade is the result of abnormally strong performance of growth strategies, not from value underperformance.23
The question presented at the start of the chapter is from a 2015 Wall Street Journal article titled “Putting Robo Advisers to the Test” and the question was attributed to Wealthfront.24 The article discussed the types of questions that automated advisors ask their users to help in determining their investments. Therefore we don’t know how the response affects the aggressiveness of the customer’s portfolio, but I and many of the automated strategies, would be inclined to buy more stocks after a market drop.
1. Eugene Fama and Kenneth R. French, The Cross-section of Expected Stock Returns Journal of Finance, June 1992. https://www.cfapubs.org/doi/pdf/10.2469/faj.v63.n6.4926 or http://faculty.som.yale.edu/zhiwuchen/Investments/Fama-92.pdf Eugene Fama and Kenneth French, The Anatomy of Value and Growth Stock Returns, Financial Analysts Journal November/December 2007
2. Josef Lakonishok, Robert Vishny, and Andrei Shleifer, Contrarian Investment, Extrapolation and Risk, The Journal of Finance, December 1994 http://lsvasset.com/pdf/research-papers/Contrarian-Investment-Extrapolation-and-Risk.pdf
3. “Using Behavioral Finance to Better Understand the Psychology of Investors” Institutional Investor, May 2010 https://www.institutionalinvestor.com/article/b150qd3bzzzl2p/using-behavioral-finance-to-better-understand-the-psychology-of-investors
4. “Characteristics, Covariances, and Average Returns: 1929 to 1997” The Journal of Finance February 2000 https://papers.ssrn.com/sol3/papers.cfm?abstract_id=98678
5. See Explaining Stock Returns: A Literature Review. https://www.ifa.com/pdfs/explainingstockreturns.pdf
6. Louis K.C. Chan and Josef, Lakonishok, Value and Growth Investing: Review and Update, Financial Analysts Journal, January/February 2004 http://lsvasset.com/pdf/research-papers/Value_and_Growth_Investing_FINAL.pdf
7. Angela Black, Bin Mao and David McMillan, “The Value Premium and Economic Activity: Long-Run Evidence from the United States.” Journal of Asset Management, December 2009 https://link.springer.com/article/10.1057/jam.2009.15
Cathy Xuying Cao, Chongyang Chen and Vinay Datar “Value Effect and Macroeconomic Risk,” The Journal of Investing, Fall 2017 http://www.iijournals.com/doi/abs/10.3905/joi.2017.26.3.041
8. Eugene Fama, Kenneth French, Value versus Growth: The International Evidence, The Journal of Finance December 1998
9. A. Michael Keppler, The Importance of Dividend Yields in Country Selection, Journal of Portfolio Management, Winter 1991.
10. John R. Chisolm, "Quantitative Applications for Research Analysts," Investing Worldwide II, Association for Investment Management and Research, 1991.
11. Carlo Capaul, Ian Rowley, and William Sharpe, International Value and Growth Stock Returns, Financial Analysts Journal, January/February 1993
12. Lewis A. Sanders, CFA, "The Advantage to Value Investing," Value and Growth Styles in Equity Investing, Association for Investment Management and Research, 1995
13. Sandip Mukherji, Manjeet S. Dhatt, and Yong H. Kim, A Fundamental Analysis of Korean Stock Returns, Financial Analysts Journal, May/June 1997
14. F.M. DeBondt and Richard Thaler, Does the Stock Market Overreact? Werner Journal of Finance, July 1985
15. Michelle Clayman, “In Search of Excellence: The Investor's Viewpoint,” Financial Analysts Journal, May/June 1987
16. Clifford S. Asness, Tobias J. Moskowitz, Lasse Heje Pedersen, Value and Momentum Everywhere, The Journal of Finance June 2013, http://onlinelibrary.wiley.com/doi/10.1111/jofi.12021/abstract
17. Patrick Dennis, Steven B. Perfect, Karl N. Snow, and Kenneth W. Wiles, The Effects of Rebalancing on Size and Book-to-Market Ratio Portfolio Returns, Financial Analysts Journal, May-June 1995
18. Todd Houge and Tim Loughran, “Do Investors Capture the Value Premium?” Financial Management, Summer 2006 https://www3.nd.edu/~tloughra/stylepaper.pdf
19. Larry Swedroe, Swedroe: Value Premium Goes Missing, May 04, 2015 http://www.etf.com/sections/index-investor-corner/swedroe-0?nopaging=1
22. Baruch Lev and Anup Srivastava, Explaining the Recent Failure of Value Investing, October 25, 2019 https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3442539
23. Value Judgments: Viewing the Premium’s Performance Through History’s Lens https://us.dimensional.com/perspectives/value-judgments-viewing-the-premiums-performance-through-historys-lens
24. Liz Moyer, Putting Robo Advisers to the Test, Wall Street Journal, April 24, 2015 http://www.wsj.com/articles/putting-robo-advisers-to-the-test-1429887456
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