The Value Outperfromance Persists...Buy You Need to Have a Long Term View to Benefit From It

The Value Premium is Alive and Well

John Rekenthaler of Morningstar wrote an interesting piece on value and small cap investing and the data of the outperformance of these sectors of the market. He was also commenting on an article over at Advisor Perspectives. 

On small cap outperformance he writes:

Actually, there is some question whether small-company stocks really do all that well. The "small-company effect" was the first academically documented anomaly, as Rolf Banz’s 1981 paper predated the initial academic research on value investing, and was once widely believed. It stands to reason that smaller companies are riskier businesses than are larger firms, and thus deliver higher returns. But performance over the past 35 years has been disappointing, particularly when the theoretical gains are adjusted for the hard reality of transaction costs.

On the value outperformance he notes

Has the value premium dissipated over time?
Happily--as I did not have the data immediately at hand--Huebscher answers his own question. He cites Ken French’s research as showing that value stocks outperformed by 4.57% annually before 1992, and by 2.78% annually since. 

The surprise is not that the advantage declined, but that it continued to exist at all. After all, the market risk associated with value stocks appears only rarely. In addition, that danger is moderate rather than severe because the alternative to value investing, growth stocks, also gets whacked by a market crash. Yes, growth stocks figure to lose somewhat less under such circumstances, but smacking into the pavement after a 35-foot fall, rather than one of 40 feet, offers scant consolation.

I would agree even at 2.78% that outperformance is quite large considering the research on this is so well known. I think the explanation here can only be behavioral what Bill Bernstein calls “the bozo effect”. But those Bozos” don’t only include individual investors but fund managers as well.

The fund managers may not be Bozos in the sense that they are behaving rationally based on their personal rewards. Such managers are fearful of “tracking error” underperforming the market which leads to outflows from their funds…which reduces their compensation and even puts their job in jeopardy.  And value strategies work in the long term. Price eventually returns to value but by that time has come plenty of short term performance chasing cash has moved out of the mutual fund that has been buying value stocks. And fund managers are paid according to assets in their funds. In other words in career management the managers may not be such “Bozos” they are maximizing their wealth if not that of the investors in their fund.

In any event I don’t think the evaluation of the small cap portion of strategies is sufficient. Small cap growth stocks are consistently the worst sector of the market in terms of risk/return. This is the domain of bubble stocks.

When one looks at the outperformance of small value stocks the data shows the small value premium effect is alive and well.

Below  is a graph of growth of wealth for the last 20 years for the S+P 500 and the msci small value index, the Russell 300 small value index and the DFA (Dimensional) Small Cap Value fund as well as a table of returns. The outperformance of small value is clear.
You can click to enlarge either of these:

But the value investor must be patient and willing to tolerate periods of underperformance. During the tech boom of the late 1990s there probably wasn’t a strategy that looked worse than tilting to value stocks. Kudos to John Rekenthaler for admitting he was among those who had a negative view of value tilted indexing investors. From a recent article of his over at Morningstar advisor: Rekenthaler writes:

Last week, I exchanged emails with an investor named Alex Frakt, who mentioned that I had addressed one of his questions in an earlier version of this column, way back at the start of the New Millennium. What question, I asked. Which was the better fund company, Vanguard or DFA, he responded. 

Oh, dear. I do recall. This was what I wrote, in May 2000:

DFA’s position is illogical. Effectively, DFA believes that when allocating among investment styles, one should ignore the market’s judgments, but that when making stock-by-stock decisions, one should strictly obey them. Curious. 

"At heart, DFA is by and for engineers. The company collected a ton of data, analyzed it extensively, and came up with an indexing scheme that it views as better and more-sophisticated than "naive" indexers like Vanguard. All this analysis is predicated on the premise that the future will mimic the past and, therefore, that the initial inputs are correct. I dispute the premise and therefore I dispute the results. More to the point, so has the market. In its 18 years of existence, DFA’s small-value tilt has harmed it more than helped. You would have made a lot more money following Vanguard’s cap-weighted approach. Surely that’s gotta account for something, too." …

Although I couldn't have predicted that DFA's small-company and value-stock tilt would thrive from that day forward, thereby propelling the company’s lineup to spectacular gains, I certainly should not have implied otherwise. There was nothing wrong in contrasting DFA’s claims with its then-lackluster results. But I should not have left the analysis at that. Quite the contrary. Early 2000 was the ideal time to mention that, at long last, DFA might be ready to fly. …

In explaining what was wrong with his analysis he notes that one reason was ::

 Succumbing to the recency effect 

That one hurts. I knew very well that the most common investment mistake was assuming that the future would resemble the recent past. After all, I had been in the business for 12 years, had made my share of such assumptions, and had watched many others make the same error. For that reason, I had become quite the contrarian. I also knew that small-company and value stocks were desperately out of favor and were priced for a rebound. But even so, I stepped into the trap. The force is strong with the recency effect.  

I give Mr. Rekenthaler a lot of credit for writing about his error…it is a lesson for all investors.