Have value funds become too valuable?
Reprinted courtesy of MarketWatch.com
Published: March 21, 2017
To read the original article click here
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.
Last year, U.S. value funds as a group were up 19.7%, according to Morningstar, while U.S. growth stocks as a group rose only 3.2%.
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.
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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 SPX, -2.14% 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.
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