QUOTE OF THE WEEK
“The most common cause of low prices is pessimism – sometimes pervasive, sometimes specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces.”
- Warren Buffett
Read more of our favorite value-investing quotes.
JUNE 7, 2015
THE RETURNS OF THE MOST POPULAR INVESTING APPROACHES, MARCH 2009 to PRESENT
We regularly conduct an analysis of various investing approaches to determine 'What's Working Now' in the investment world. Typically we do a fairly in-depth study using several dozen key metrics we have found are indicative of the current market environment. However, we would like to show you, in broad terms, which approaches have been ineffective over the last market cycle and which one have succeeded. Therefore, we have run a multitude of tests with our main factor, formula, and system-testing software provider, Portfolio123.com of Chicago, IL, US.
For the purposes of this demonstration, we started our runs on March 9, 2009. That's the date when our Intelligent Market Risk Analysis gave us a 'Market Up' signal to load up on deeply undervalued stocks following the market crash of 2008. We could have started at any number of different points, but using the bull rally since March 2009 as a backdrop is a good way to view what approaches have performed and which ones have failed miserably.
In each of the charts below, the blue line represents the Russell 3000 Index, a broad index of small-cap, mid-cap, and large-capitalization companies. The line in red represents the investing approach that is being compared. Each chart identifies the approach along with the annual return it was able to achieve over the six-year span.
The Growth approach identifies the top 5% of stocks as measured by improvements in EPS over the prior year, trailing 12 months, and the last five years, as well as recent and longer-term EPS acceleration. This approach also takes into consideration revenue improvement over last year's quarter, the trailing 12 months and the last five years. The rate of acceleration of sales, both recently and over the long term, are also considered.
Unfortunately, while growth is Wall Street's darling and the topic of just about every conversation if you watch CNBC or Bloomberg or read market-related websites or magazines, this obsession is leading investors astray. A careful selection of the top 5% of growth stocks, rebalanced weekly, cannot come close to matching the plain-vanilla Russell 3000 Index. Growth produced an annualized return of just 17.37% while the Russell 3000 produced about 23% AR over the six-year period.
The Quality approach identifies the top 5% of stocks as measured by operating margins, asset turnover, return on investment, return on equity, and financial-quality measures such as interest coverage, debt to total capital, and current ratio.
Probably the second most desired stock type by investors, 'quality' also comes up short when it comes to performance, producing an annual return of just 16.01% for the six-year period we analyzed. So much for the incessant desire by investors for 'high quality, high growth stocks.' The likely reason these stocks underperform is that their well-regarded future expectations are already included in their current price. If everyone can see the stock has growth potential or a company has robust financial, it's likely those company's prices have already been bid up to those future expectations and probably far beyond.
While 'sentiment' may sound like something you felt for your high-school sweetheart, in this context it refers to the stocks that are most well-liked by Wall Street analysts and the investors who follow them. In this case, 'Sentiment' refers to
1. Estimate Revision
2. Earnings Surprise
3. Analyst Recommendations
4. Upgraded Analyst Recommendations
You can see that the stocks that were highly ranked by analysts did poorly through the turmoil of 2011 and 2012, made up ground in the second half of 2013, but responded poorly through 2014. However, in the last six months, the stocks have taken off and beat the Russell 3000 index by a few percentage points. Don't break out the champagne yet though, it appears that a dip is developing at the end of that volatile red line. Based on observation of many thousands of charts, the returns of 'sentiment' based stocks shown in the graph below are now overbought and ripe for reversion to the mean (i.e., downward).
Benjamin Graham advised value investors to stick with quantitative rather than qualitative measures. Most of an investor's effort should be "devoted to the figures," wrote Graham, because the qualitative elements would include, "a large admixture of mere opinion." This is particularly applicable to the 'Sentiment' approach to selecting stocks based on analyst recommendations. Several academic studies have determined that analysts ratings are incorrect greater than 90% of the time.
While again one of the most popular investing styles for retail investors, Momentum, or 'Mo-Mo,' stocks have to be one of the biggest disappointments going. Similar to stocks that have been growing sales and earnings, or a company that is making headlines, buying companies with a price that's rising is more comfortable than buying one with a priced headed south. Strange to say, perhaps, but it is for this very reason that these stocks do so poorly. It's the result of mean reversion – the tendency of high flyers to come crashing down to earth and the downtrodden to rise from the ashes that account for the majority of disillusioned investors throughout the world.
As Warren Buffett said in this week's 'Quote of the Week, "The most common cause of low prices is pessimism – sometimes pervasive, sometimes specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces.”
In our analysis, momentum stocks were able to ferret out an annual return of just 11.37% over the six-year period. However, all of the gains came in the last six months. As of January 1, 2015, the total return for this (nearly) six-year long study's approach om Momentum would have been precisely 0%. Shall we credit luck for a 100% gain between January 1 and June 7, 2015? If there's something that's more at work with the Momentum approach's 5-week success, consider the next section and chart, from Momentum 2007.
Notice in the chart above that we mentioned that momentum stocks have been rising sharply for the last five weeks. That's actually a little ominous. When checking in on the Momentum approach back to the last market top in 2007, we see that momentum stocks were also on fire then, with a double peak in July and October of 2007, just before the big selloff began that became the worst market crash in 80 years.
VALUE – USING MID/LARGE-CAPITALIZATION STOCKS
We have saved the best for last, as value stocks rose straight away from the bottom of the market in 2009 and 2010 and never dropped below the Russell benchmarks during the entire six-year period. They struggled a bit, along with the rest of the market, in 2011 and 2012 but had an incredible year in 2013! However, since the beginning of 2014, value stocks have been mostly flat. That's not unexpected, given the incredible returns of 2013, and it's likely that this long consolidation will have soon worked off the overheated conditions.
These value-based ranking systems emphasize fairly generic 'price-to-a-fundamental measure' such as Price/Earnings, Price/Sales, Price/Book Value, and do not include the more sophisticated approaches we have developed and refined over several decades. Nevertheless, these bare-bones value criteria produced returns that were nearly double the returns of the next best approach, 'Sentiment,' and quadruple the 'Momentum' approach to selecting stocks.
VALUE – USING SMALL-CAPITALIZATION STOCKS
Small-cap value stocks exhibited more volatility, as is expected from smaller companies with less stability than their larger brethren, but with these generic value settings, the results were slightly less than the same approach applied to mid-and-large-cap stocks. The results were still near an annual return of 45%, which is far above the second closest approach, Sentiment at 26%.
WHY VALUE OUTPERFORMS EVERY OTHER APPROACH BY A WIDE MARGIN
Why is it that the value approach outperforms growth, quality, sentiment, momentum and any other type of investing approach? The reason is one of the most powerful forces in nature, human enterprise, and stock prices; 'reversion to the mean.' Benjamin Graham warned in Security Analysis that the inclusion of quantitative and qualitative factor evaluation without taking into consideration the impact of mean reversion would inadvertently lead to errors of overvaluation.
Graham said, "It is natural to assume that industries which have fared worse than the average are "unfavorably situated" and therefore to be avoided. The converse would be assumed, of course, for those with superior records. But this conclusion may often prove quite erroneous. Abnormally good or abnormally bad conditions do not last forever. This is true of general business but of particular industries as well. Corrective forces are usually set in motion which tend to restore profits where they have disappeared, or to reduce them where they are excessive in relation to capital."
Companies that have experienced high growth with high returns on investment attract competition that cuts into margins deteriorates profits, and subsequently their fortunes suffer (along with their stock price). On the other hand, companies that have experienced trying times, perhaps seeing losses and had their stock price beaten-down, invariably make changes to management, revise product lines, raise new capital, redeploy assets and see their fortunes rise again.
It's easy and comfortable to invest in the growing, well-known, highly profitable, or exciting company that's making news. It's difficult to purchase stock from the bargain bin that many believe has seen its better days and is immersed in pessimism. However, like Mr. Buffett, we appreciate the prices that pessimism produces - and we especially like the resulting stock returns when the inevitable reversion to the mean occurs in our company's stock price. Our RELATIVE VALUE Portfolio has a return of 95.62%, and our DEEP VALUE Portfolio has a documented return of 156.76% since they were launched at the market open on March 9, 2009.
IMPORTANT NOTE: We revised our RELATIVE VALUE Portfolio in January of this year to add a small element of MOMENTUM to the selection criteria because we saw it was working well in actual performance.
We hope that we have thoroughly discussed the issues in this Value Alert, and you can implement these ideas to your benefit. Our objective is to give you the best value-oriented investment information possible, with ease of use, timely identification of the issues that affect our portfolio positions, and a full understanding of our approach. If you have any questions or comments, please contact us with a support ticket.
Best Wishes for Another Week of Intelligent Value Investing,
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Opinions expressed herein by the author are not an investment recommendation and are not meant to be relied upon in investment decisions. The author is not acting in an investment advisor capacity. This is not an investment research report. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations to its accuracy. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings, and consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice. Shareholders, employees, and writers associated with IntelligentValue, Inc. may hold positions in the securities that are discussed. If you are not sure if value investing or a particular investment is right for you, we urge you to consult with a Certified Financial Advisor. Neither IntelligentValue.com, nor any of its employees or affiliates are responsible for losses you may incur.