Have value funds become too valuable?
For many years I have advocated that investors overweight the equity side of their portfolios toward value funds, which very often outperform more popular growth funds.
But recently, I’m hearing from people who are starting to question the basic premise of value investing: that certain stocks are underpriced bargains and likely to outperform once their “real value” is more appreciated by investors.
To explore this topic, I interviewed Richard Buck, my longtime friend and writing partner. What follows has been edited for clarity, style and length.
Richard Buck: As you know, Paul, I thoroughly buy into your advocacy of value investing. But lately, I’ve started to wonder if success could be the death of the value proposition.
As a value investor, I love that. But I have this nagging concern: Isn’t there a point when the very success of value funds takes away their promise? In other words, their prices are now high, not low.
I’ve always thought that value investing makes me sort of a contrarian. But maybe a real contrarian should invest in growth instead of value right now.
Paul Merriman: You raise a very interesting point, one I’ve heard from others as well. A big part of my response is based on two words you just spoke: “right now.”
That implies that you want to do what’s right at this very moment. And while that’s understandable, it’s likely to lead you down the wrong path.
Look at it this way: Although nobody can reliably predict the market in the short term (anything can happen), let’s suppose for the sake of discussion that value funds have finally reached the point where they are fully valued.
Let’s suppose further that growth stocks are about to take off on a streak of outperforming their value counterparts.
And let’s go even further and suppose you have identified the precise time that this shift will start (even though that’s so statistically unlikely that it’s not worth considering seriously).
So suppose you sell your value funds and buy growth funds instead, and you make some good returns for a while.
That will be very satisfying, but you have now become a short-term investor who depends on some sort of market timing.
At some point, you will have to confront the same question all over again: When (if ever) will value stocks once again become the better choice?
Buck: You are pointing to the well-known difference between the short term and the long term.
But I can’t help thinking that “the long term” is really made up of a series of short-term periods. When it’s obvious that a change in the winds is overdue, shouldn’t a smart investor act accordingly?
Merriman: If you are the captain of a sailboat, yes, that’s the smart approach.
Winds and weather can be predicted well enough to dictate a change in plans. But in more than half a century of studying the markets, I have never found anybody who can reliably and consistently predict short-term stock trends. And that is really what you are talking about.
Buck: So you’re saying I might be wrong in my analysis?
Merriman: Yes and no. Your observations about the recent success of value funds are spot on. But I don’t think that means you should switch gears and become a growth investor.
Buck: Then what am I to do with my brilliant analysis?
Merriman: There’s a better way to respond than what you are proposing. It’s called rebalancing.
Periodically, you sell some of the assets in your portfolio that have been outperforming (which in this discussion would be value funds) and use the proceeds to buy more of what has been lagging (in this case, growth funds).
This applies more broadly to the proportions of your portfolio that are in equities and in fixed-income.
Buck: Well, of course I know about rebalancing. But it just seems sort of boring.
Merriman: It may be boring. But it will keep you on course. If you’re right that value stocks are overvalued, rebalancing will force you to sell some of them — at a nice profit, I might add.
More important, taking a disciplined approach will help make sure you get the benefits of value stocks’ long-term performance.
One of my favorite graphics is the Callahan Periodic Table, which has been updated to reflect 2016 data.
This table ranks the performance, year by year, of 10 asset classes.
You’ll see that, in 10 of the most recent 20 calendar years, U.S. small-cap value stocks were ranked in the top three. (In six other years, they were in the bottom three!)
Similarly, U.S. large-cap value stocks made the top three rankings in five years and hit the bottom three only twice.
Buck: You are a numbers guy, through-and-through, Paul. I have a hunch you have more numbers up your sleeve.
Merriman: You’re right: I’m never tired of numbers.
Here’s one I recently learned from BTN Research, a service to which I subscribe: “The ongoing bull market for the S&P 500 US:SPX reached 8 years in length as of the close of trading on Thursday 3/09/17. Over the 8 years, the index has gained +314.4% (total return), a compound rate of return of +19.4%.”
Buck: Wow. That means somebody who stuck with that index would have quadrupled his money in eight years. I certainly didn’t do that with my portfolio.
Merriman: Most people didn’t. In fact, I know lots of investors who are still trying to figure out how to sensibly get back into the market after they bailed out in 2009.
This eight-year performance made me wonder: How often does the market compound at more than 19% over a period of eight calendar years?
Using an excellent database put together by Dimensional Fund Advisors, I posed that question for a few major asset classes going back to 1928.
It turns out that there have been four 8-year periods when the S&P 500 appreciated more than 19%.
Large-cap value stocks racked up 11 periods of eight calendar years with growth over 19%.
Buck: How about the small-cap value stocks you’ve written about so many times? How did they stack up?
Merriman: That’s something I wanted to know, too.
I found 26 eight-year periods in which small-cap value stocks did better than 19%. The average compound return of those periods was 22.8%, better than the S&P (20.7%) and large-cap value (20.5%).
Those higher (and more frequent) impressive returns came with more volatility, of course. But these numbers seem to indicate a high probability of greater expected returns to make that risk more worthwhile.
So I ask you: Which would you rather have: an asset class that quadrupled investors’ money 26 times (small-cap value), or one that did so only 11 times (large-cap value) or only four times (S&P 500)?
Buck: When you put it that way, it’s an easy question to answer.
Merriman: I think so too, at least for long-term investors who can stomach the risk.
My next article will focus on a handful of value funds and ETFs that are worth considering for your portfolio.
Reprinted courtesy of MarketWatch.com.
To read the original article click here.
Most savvy investors (and certainly Warren Buffet) are well acquainted with the attractions of value stocks and value funds. Over long periods of time, value funds (those that invest in “unloved” and less popular stocks) have consistently outperformed popular indexes such as the S&P 500 SPX, -0.17%
This week I’m going to show how investors with long time horizons — perhaps those in their 30s and younger — can put this fact to work for them with an all-world, all-value equity portfolio.
Where to begin
This is a simple variation on the Ultimate Equity Portfolio, which reflects the way most of my own equity money is invested. As I have written many times before, I believe this Ultimate Equity Portfolio is the best possible equity combination for most investors.
|Portfolio 1||Portfolio 2||Portfolio 3|
|Portfolio makeup||S&P 500 Index||Ultimate Equity*||Worldwide Value**|
|46-year compound return||9.25%||11.28%||12.43%|
|Annual standard deviation||17.3%||18.0%||20.6%|
|$100,000 grew to (annually rebalanced)||$5,859,979||$13,645,527||$21,950,359|
|* 10% each: S&P 500, U.S. large value, U.S. small blend, U.S. small value, U.S. REITs, international large blend, international large value, international small blend, international small value, emerging markets.|
|** 25% each: U.S. large value, U.S. small value; 20% each international large value, international small value; 10% emerging markets value.|
As noted in the table (which identifies it as Portfolio 2), this is made up of equal parts of 10 important asset classes: the S&P 500, U.S. large-cap value, U.S. small-cap blend, U.S. small-cap value, U.S. real estate investment trusts, international large-cap blend, international large-cap value, international small-cap blend, international small-cap value and emerging markets stocks.
Over many medium-term and long-term periods, this combination has outperformed the S&P 500 without adding significant risk. Here’s an article that gives a full explanation of how this portfolio is put together and why it has worked so well.
Although that portfolio is weighted toward value, it still contains a lot of growth stocks (in the blend funds), which have tended to lag behind value stocks.
Less is more?
In recent weeks I began wondering: What would happen if such a portfolio were stripped of everything except value funds?
In my column last week, I answered part of that question as it would apply to a simple four-fund U.S. equity portfolio. The answer: Investing equally in only two funds (U.S. large-cap value and U.S. small-cap value) led to significantly higher 15-year returns and 40-year returns, when compared to a four-fund portfolio that also included the S&P 500 and small-cap blend stocks.
The additional statistical risk of this change was not very significant.
So I then wondered: What would happen if we modified the 10-fund Ultimate Equity Portfolio by reducing it to only five value-oriented funds?
You’ll see the answers in the table.
The time period in this comparison is shorter than the one I used to compare the U.S.-only portfolios last time. That’s because historical data for some international asset classes is somewhat less reliable prior to 1970.
Taking chance out of the equation
But going back to 1970 still provides 46 years of data, which is certainly enough to discern patterns that are not likely to be just the result of random chance.
As you have probably noticed already in the table, over the 46 years from 1970 through 2015, this worldwide value portfolio (labeled as Portfolio 3) turned in a compound return of 12.43%, which is 1.15 percentage points higher than the 11.28% return of the Ultimate Equity portfolio. That seems like a small number, but it’s actually a 10.2% boost in the compound return.
Either way, that increase may still seem like a yawner.
But over 46 years, as you can see, it made the difference (on a $100,000 initial investment) between $13.6 million (Portfolio 2) and nearly $22 million (Portfolio 3).
That’s a boost of nearly 61% in dollars.
Not every investor can set that much money aside for 46 years, of course. But young people in their 20s can sock away $5,000 a year (sometimes more, of course) toward retirement. And it’s not hard to imagine that such money could remain invested for nearly half a century before it is needed.
An all-value portfolio is likely to work for reasons that have been well known and well-documented for a long time.
- Value stocks are ones with prices that make them relative “bargains” in relation to their underlying fundamentals such as sales, profits and book value.
- The bargain prices often result from reasons quite unrelated to the actual prospects for specific companies.
- Certain industries go “in and out of favor” with institutional investors; when they regain “preferred” status, those industries (and the stocks that make them up) attract investors who are willing to pay higher prices.
Still, an all-value portfolio is unusual, and many investors will be uncomfortable abandoning funds that own popular growth stocks like Google GOOG, -0.01% (now part of a company named Alphabet), Facebook FB, +0.63% , Amazon AMZN, -1.56% , Apple AAPL, -0.90% and Home Depot HD, +0.61% .
In addition, the majority of the stocks in this portfolio’s funds are headquartered outside the United States.
However, the additional return of the Ultimate All-Value Equity Portfolio may be compelling for those who are comfortable with international stocks and who can take the long view.
To learn more, check out my podcast: The ultimate all-value equity portfolio.
Also, check out my free 2 ½ hour video, “Financial Fitness Forever: How to make more money, at less risk, with more peace of mind.”
Richard Buck contributed to this article.