Warren Buffett discussed the folly of backward-looking investing during the “Nifty Fifty” market of the early 1970s in a now-famous Forbes article titled “You Pay A Very High Price In The Stock Market For A Cheery Consensus.”* That article made a huge impression on me as a college student pursuing a finance degree and was the impetus for a paper I wrote on value investing.
The madness of paying very high prices for stocks ended with the 1973-1974 market decline and the madness of eschewing low-priced stocks (really, all stocks) took its place. This is the foolishness Buffett was calling out in the article. The “smartest of the smart” were still selling stocks in 1979. Today, I’m afraid we’re witnessing a similar phenomenon. With all the attention poured onto Apple, Amazon, Microsoft, Alphabet, and Facebook, this is shaping up as a “Nifty Five” market.
In 93 years of US stock market history, we have seldom seen the performance gap between large growth and small value stocks that we see today. The last time this occurred was 20 years ago, during the dot-com hysteria. This time, the divergence in performance has developed in about two years. You can perceive this trend as the death of value, or you can see it as an enormous opportunity that doesn’t come around very often. I choose the latter, and here’s why.
First, the expected return premium from value stocks is not derived from simply observing past market or asset class data or the performance of stock-picking gurus. Rather, it’s derived from risk. The lower relative prices for value stocks reflect the market’s view that value stocks are riskier and therefore undeserving of the higher valuations of large-growth companies. No one who understands market pricing can dispute this conclusion. The real debates address whether the risk is worth taking and the best way to take it.
I was convinced of the merits of value investing by studying Buffett in the 1970s and 1980s. My beliefs were strengthened and refined through the financial science presented by Fama and French in 1992. The natural next step was to develop, in Equius, an investment advisory and communication discipline that would allow our clients to benefit from this knowledge.
Steeped in the logic supporting a Buffett/Fama/French philosophy of pricing and armed with special mutual funds introduced in 1993 and 1994 by Dimensional Fund Advisors, we began investing like Buffett but in a more modern and diversified way. Our expectations were motivated by the outcomes suggested in Chart 1 (blue bars). By the way, like Buffett, we reject short-term speculation and market timing.
From July 1926 through December 1994, US large and small value stocks outperformed the overall stock market by 2.8% and 5.3% annually, respectively.
And from 1995 to mid-2007 (the green bars), the return premiums for US large and small value stocks remained robust, at 2.5% and 8.0% annually, respectively.
But what isn’t shown is that during the first five years of this period (1995-1999), the total US market outperformed US large and small value stocks by 8.4% and 11.8% annually, respectively! In other words, despite an agonizingly long five-year stretch during which very large, mostly tech-related companies blew the cover off the ball, value stocks still won out for the full period.
Then the global financial crisis hit and all stocks took a beating. Still, through August 2018 US small value stocks provided a 3.6% annual return premium while US large value stocks lagged slightly behind (Chart 2).
As the wise philosopher, Yogi Berra, once said, “it feels like déjà vu all over again.” Currently, we’re experiencing another annoying lag in value stock performance. Chart 3 illustrates this trend, extending the time period from the previous chart to June of this year.
A 1.1% annualized premium is the reward investors enjoyed for assuming the higher risk of US small value stocks over a period of 25 and a half years? Ugh! No wonder some investors have doubts about a multi-asset class portfolio. So what happened?
Covid-19 happened. Apple, Amazon, Microsoft, Alphabet and Facebook now make up 25% of the market value of the S&P 500, and the market got slammed by Covid-19. When the dust settled, the “winners” have been the massive, tech-oriented growth companies, and the “losers” have been everyone else—for now.
This is the epitome of “end-period bias”—a term I’ve coined for years to describe these extreme short-term periods tagged on to a much longer return data series. Over the first three months of this year, US small value stocks dropped 41.5%, accounting for the bulk of the end-period bias shown in Chart 4. Three months!
Investors who lack this perspective risk altering their long-term investment plans at the worst possible time. Chart 5 below illustrates this potential. It shows the difference between the returns of US small value stocks and the US total market.
Of the 93 (on a yearly basis) two-year rolling periods starting July 1926 and ending June 2020 (i.e., July 1926 to June 1928, July 1927 to June 1929, and so on), the worst period has been these past two years.
If we dig even deeper and look at the 1,105 (on a monthly basis) two-year rolling periods (i.e., July 1926 to June 1928, August 1926 to July 1928, and so on), the four worst periods ended in March, April, May, and June of this year. Three of the next five worst periods ended in the final months of 1999.
We know what followed. Over the “lost decade” from 2000 to 2009, the US total stock market declined by 4%, while US small value stock prices rose by 192%.
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A related topic is the recent performance of the Dimensional value funds versus the plethora of mutual funds and exchange-traded funds introduced over the last 20 years to compete with them. We fully expect, as I’ve written many times, that other index funds targeting value stocks should outperform the Dimensional funds during times like these!
A careful examination reveals no flaws in the Dimensional fund structure or their management, but rather less of a tilt to small-cap and value stocks in the funds of other providers (their shareholders are paying more for their stocks). It’s no more complicated than that. When it comes to “trust, but verify,” we will stay with the firm and the experts who launched this approach until convinced to do otherwise.
* Linked source is a 2008 reprint of the original article, which was published in August 1979.
** Fama/French Total US Market Research Index, Fama/French US Large Value Research Index, and Fama/French US Small Value Research Index.
Equius Partners, Inc. is a Registered Investment Advisor.
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Please consider the investment objectives, risks, and charges and expenses of any mutual fund and read the prospectus carefully before investing. Indexes are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio.
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