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Why You Should Stick With Value

By: Frank Armstrong

You have all seen variations of the “mountain chart” which illustrates the absolute dominance of equities over fixed income. It’s apparent that a long term investor enjoys a situation stacked heavily in his favor. On a year to year basis the outcome is variable, and sometimes you may underperform the lower risk alternative. This is inescapable.

Over the longer term, the strategy of selecting stocks over fixed income pays off handsomely;

You will win far more often than you will lose.

Your average winnings will be higher than your average losses.

Cumulatively the longer you stick to the strategy the more certain are that you will be very happy at the end.

There is good economic theory explaining your success: Because investors generally do not like risk or volatility they demand a higher return to accept that risk. Stock prices in the aggragate are discounted to the point where investors can expect their higher expected returns.

Historical data in every global economy supports the dominance of stocks over bonds in multiple time frames.

Economists call the outperformance of stocks relative the equity premium. And as you can see it’s very robust. Here’s the amount that US stocks beat Treasury Bills from 1928 to 2018:

Growth Of Wealth

Monthly: 1/1/1928 – 12/31/2017

 

T-Bills, the zero risk investment, returned 3.36% during the extended period. But, the market returned 9.70%, so the equity premium was a hefty 6.34%. So, a dollar invested in T-Bills in 1928 would have grown to $20, while a dollar invested in stocks would have grown to $4166. That’s the whole argument for assuming equity risk in a nutshell.

It would be nice if the equity premium showed up every year. But, while that may happen in some alternative universe, it’s not going to happen here.

While the long term implications are clear, the short term performance of the premiums is anything but clear. There is a well known randomness to equity premium appearance.

Below illustrates the pattern of over and underperformance of the Market versus the Treasury Bill annually from 1928 to 2017.  The market provided more wins than losses, greater average wins than losses and as shown above cumulative overperformance.

Randomness equals variation which equals investor risk. While that risk is annoying, equity investors are handsomely rewarded for enduring it. And that random disappointment may endure for extended periods during which the premium may be absent without leave (AWOL).

As an example of an extended period of underperformance, there was a 19 year period where treasury bills outperformed stocks, a period that ended just as Business Week published their infamous “Death of Equities” cover story in August of 1975. That was a true test of faith which illustrates that patience is required to capture the benefits of the strategy. Once again, the longer you stick to the strategy, the more certain you will be to capture the outperformance.

Please note: Underperformance does not necessarily mean loss of capital, it means that you made less than some other asset class.

But, that’s not the end of the story.

Parts of the market will outperform the broad market by a satisfying margin. For instance, value stocks have historically outperformed the market as a whole.

Value stocks are cheap stocks. And they got to be cheap because they are in some degree distressed companies.

Investors beat down the price of value (cheap) stocks to the point where looking forward they can expect higher returns than the market as a whole. The factors that explain this outperformance are identical to those that explain the outperformance of stocks relative to bonds. See the bullet points above.

The amount of that overperformance is called the value premium. The value premium is independent of other premiums so it might be positive or negative whatever the equity premium is doing. Like other premiums it shows up randomly and can be AWOL for an extended period. Nevertheless, the value premium is generous.

Growth Of Wealth

Value v. Market

Monthly: 1/1/1928 – 12/31/2017

 

The market returned 9.7% while value stocks returned 11.55%. The difference between an accumulation of $4166 and $18,844 is not trivial.

So if we chose cheap stocks (value), we should expect a substantial outperformance over and above the market as a whole. But, or course, this outperformance comes with its own randomness. Much as we would like it to doesn’t happen every year. It’s an independent variable with a positive expected return just like any other factor of excess returns. But, again more wins than losses, bigger average wins than losses, and gratifying long term outperformance.

 

Any investment strategy will have periods of underperformance. That’s baked into the investment experience. But, history and economic theory agree that value is a viable strategy for outperforming the market over time.

Looking at the last 11 years alone, the value premium has been AWOL. Value investors may be forgiven for feeling a little frustrated. I get it. Of course, I’d love to tell you exactly when the value premium will reappear. I can’t. But, I’m  highly certain that for disciplined investors tilting your portfolio toward value holdings will pay off handsomely over the long haul.