Monthly Archives: February 2016

Post: 1027 February 23rd, 2016

A Vanishing Value Premium?

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 31 December 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 counselled 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 at 31 March 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. AWall 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 annualised 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 annualised 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.

Post: 1016 February 23rd, 2016

Expectations vs Reality

You catch the news on the way into the office.  Yesterday the market reached a 10% low relative to its last peak.  Immediately in your mind you begin to filter your clients and prospects.  Some will care and others won’t.  You’re grateful most of your clients either don’t pay attention to that stuff or don’t seem to react.

Yet in your mind you can picture three or four faces.  These are clients that seem to consume the news and, when the market reaches certain thresholds, they become unnerved.

They are unnerved for a simple reason.  In their mind a pattern has formed.  Their hidden belief is that because the market has gone down 10%, then it will go down another X% (fill in the blank with 5%, 10%, 15% or what have you).

In other words, they don’t mind so much that the market has gone down, but they mind a lot about where they think it’s going to go.

We can’t really blame them.  Humans are programmed to form patterns – this is why we see constellations in the stars.  As Wall Street Journal personal finance columnist Jason Zweig says in his fantastic book Your Money and Your Brain, “After two repetitions of a stimulus – like, say, a stock price that goes up one penny twice in a row – the human brain automatically, unconsciously, and uncontrollably expects a third repetition”.

This behaviour is everywhere, but it especially hurts us with money.  Consider how many fortunes have been blown in the casinos of the world because the gambler thought they were on a ‘hot streak’.  Rolling consecutive sevens in craps or hitting 21 on consecutive hands in blackjack makes us think, for some reason, that the next seven or 21 is more likely than it really is.

Carl Richard illustrates the phenomenon this way:
expectations

How do we counteract this behavioural bias?  By being relentless with the truth.  And the truth is this: a recent down turn in the market never has, and never will, be any predictor at all of future negative returns.  The graph below shows the how the market performed 12 months, 24 months and 36 months after market falls of varying magnitudes from a previous market high point.

Across the board the median case is that markets were positive after any size drop.  Looking at the upper and lower quartiles shows a distribution of results is possible (of course) but it’s mostly positive.  We use the S&P 500 to take this illustration all the way back to World War II.

 

S&P

 

Salient for current markets, the median returns after the markets have fallen 10% is a positive 8.19% for the next 12 months, which is right around what the market returns on average anyway.

As advisers, it may be useful to show this chart to clients so they can read the facts, but perhaps it’s even more useful to memorise the facts for ourselves.  How powerful is it if, over the phone, you can say, “I know you’re concerned, Joe, but since the end of World War II, the market has lost 10% from a previous high a total of 14 times.  In those cases, the median return 12 months later was 8.19%.  Based on that, I don’t think we should read too much into recent performance.”

Of course, there is another approach.  An adviser we work with recently told us they say to clients who ask, “I know the market just lost 10%.  Isn’t it great?”

“What?” says the client, slightly exasperated.

“Listen, if the market didn’t ever go down then we would never earn the premium for owning shares, and without the premium for owning shares we’d never reach our financial goals.  We need volatility!  Don’t worry, we haven’t taken on any more volatility than you can handle”.

“Oh, ok” says the client, and changes the subject.