Destruction of Value

About ten years ago, I attended an investment conference that brought together students and faculty from a number of MBA programs on the East Coast.

Eugene Fama was one of the keynote speakers at the event. This was a few years before he won the Nobel Prize, but it’s fair to say that he was already quite a celebrity on the academic circuit.

I don’t recall the exact topic of his speech, but I do remember that on the back of meeting him, I was sufficiently inspired to read up on the Fama-French model, which forms a big cornerstone of Eugene’s work.

For those who are interested in asset pricing theory, you can read more about the model here. But in short, highly simplified way, it boils down to the following:

• Over long periods of time, value stocks tend to outperform growth stocks
• Similarly, small-cap stocks tend to outperform large-cap stocks

At the time, I had just entered the second year of my MBA program.  Times were good – I had already lined up a full-time job offer, had a few scholarships coming my way, and was about to start a part-time teaching assistance gig on campus.

In other words, I had money to spare. So I’ve done the very thing personal finance bloggers always tell you not to do.

That is, I maxed out my low-interest student loans, added some cash on top, and invested everything in the US stock market.

Risky Business

Looking back, it was one of the best money moves I’ve ever made. The year was 2010, the S&P 500 was hovering around 1,200.  As of today, it’s up nearly three times – and that is before you take dividends into account.

In addition, the FX had actually moved in my favour, so when I was repaying my student loans a few years later, I scored another 10% paper gain.

Unfortunately, I had taken Fama’s asset pricing theory a little close to heart, meaning that I’ve put a big chunk of my money into value stocks.

If you look at things over the long run, it’s all fine and dandy. On a twenty-year basis, value stocks (I’m using the IWN ETF here as a proxy), outperformed the S&P 500 by about 30%*.

Not too shabby – until you zoom in on the past decade, which incidentally happens to match my investment horizon.

Up until 2014, value stocks were just about keeping pace with the S&P 500.  Subsequently, things only got worse for the value faithful.

And as we all know, 2020 has been an absolute blowout… for growthy tech stocks, which left their value counterparts deep in the dust.

Excuses, Excuses

There are a number of possible explanations being bandied around for this stark divergence of fortunes.

One is that once investors realized value stocks were being mispriced, they promptly piled in, bidding prices up and driving down returns.

Another one is that defining value by looking at the company’s balance sheet does not reflect today’s realities. Plants and factories no longer matter. Intellectual property is where it’s at – and those conservative accountants never put the right number on it.

There’s even a theory that says that “true” value stocks have gotten bid up in price (thus no longer fitting the “value” category), and what’s left behind is the proverbial bait, luring investors into a classic value trap.

Unfortunately, neither Fama nor French are of much help here.  They revisited the topic in 2018, only to conclude:

Negative equity premiums and negative premiums of value and small stock returns relative to market are commonplace for three- to five-year periods, and they are far from rare for ten-year periods. Given this uncertainty, investors who will abandon equities or tilts toward value or small stocks in the face of three, five, or even ten years of disappointing returns may be wise to avoid these strategies in the first place.

In other words, “man up and ride the rollercoaster because who knows how much longer this period of underperformance may last”.

To give them credit, the original study does reference periods of underperformance as long as 15 years, so they’ve got until 2025 or thereabouts for their thesis to play out.

So where does this leave me – and anyone else unlucky enough to have an allocation to value stocks?  The lessons I draw here are as follows:

Lesson 1: It’s okay to be an “active-passive” investor, allocating a portion of your portfolio to specific pockets of the stock market (whether geographically or otherwise).

However, make sure you keep the allocation within reason. You don’t want it to be the tail that wags the dog and causes all kinds of sleepless nights.

Lesson 2: Make these decisions with a long-term perspective in mind.  It’s easy to be a long-term investor when everything is going swimmingly well, like it has been for the past 11+ years.

Frankly speaking, even 2020 wasn’t that much of a scare, with just a couple of rough weeks before the Fed ultimately stabilized the markets.

But at the end of the day, it’s persevering over long, multi-year (or even decade-long) stretches of underperformance that separates the truly successful investors from the rest. Kind of like the people who kept piling into the S&P 500 between 2000 and 2009.

Lesson 3: Learn to differentiate between theory and practice. I’m not throwing rocks at Fama here (he happens to run a pretty successful hedge fund, validating his track record as an investor).

However, you want to think long and hard before making investment decisions on the basis of academic studies and papers… which conveniently segways into the most important lesson of all:

Lesson 4: Own the world.

I cannot say this enough. Unless you have true conviction on a specific investment thesis – and the ability to stick with it for 10, 15, or even 20 years –  you are much, much better off putting your money into a global tracker and forgetting about it.

Happy investing!

*Note that this is price return only. My big beef with free stock charting software is that it’s very hard to get a proper total return benchmark. That being said, the dividend yields on the broad index and the value stock ETF are broadly in line, so we are not too far off the mark.