If you’ve been an evidence-based investor for a while, you know the drill. You’ve already built a low-cost, globally diversified portfolio to help you achieve your personal goals. You’ve done so by tilting your portfolio toward or away from empirically-tested long-term sources of expected returns – and their risks. When those risks arise, if your goals haven’t changed, neither should your portfolio.
Let’s assume you’ve already embraced this advice, and are relatively comfortable maintaining your investment resolve. You also may be aware that investments concentrated in value stocks have delivered higher long-term returns than their growth stock counterparts. As “Multifactor World” blogger Jared Kizer recently noted, value stocks have outperformed growth stocks by 4.8 percent per year over the period of 1927–2017.
But it’s also no secret that the value premium has been hiding for quite a while. At least in U.S. markets, value stocks have been underperforming relative to growth stocks for around a decade.
This has led some investors to wonder whether the value premium has lost its mojo. Even among financial academics and practitioners, healthy debate exists over what to make of the past decade. Are the underwhelming returns a temporary, if painfully long bump in the road, or does it represent a permanent new reality for value stocks?
We won’t keep you in suspense: Nobody knows for sure what the future holds; we cannot guarantee success. But based on historical and ongoing evidence, we have found no compelling reason to alter our approach to value investing.
In this two-part series, we’ll explore why we feel it remains in your best interest to keep the faith on value investing, relative to your personal financial goals and risk tolerances.
To support our continued faith in value investing, we begin by describing its historical roots. In 1992, professors Eugene Fama and Ken French published a landmark study in The Journal of Finance, “The Cross-Section of Expected Stock Returns.” Their work gave birth to the Fama/French three-factor model, which suggested three sources of expected returns could explain almost all of the differences in returns among different portfolio builds:
- The equity premium. Stocks have returned more than bonds.
- The small-cap premium. Small-company stocks have returned more than large-company stocks.
- The value premium. Value company stocks have returned more than growth company stocks. Value companies are those that appear to be under-valued relative to growth companies. They exhibit lower ratios between their stock price vs. their various business metrics such as book value, earnings, and cash flow.
What does this mean to you as an investor? It suggests financial analysts can take any two investment portfolios and compare their long-term performance using just these three factors. With more than 90% accuracy, the analysis should explain why one portfolio returned, say, 10% annualized over 20 years, while the other one only returned 5%.
Put another way, the Fama/French three-factor model showed us that, costs aside, almost all that matters is how you’ve allocated your holdings among (1) stocks vs. bonds, (2) small-cap vs. large-cap stocks, and (3) value vs. growth stocks. Stock-picking or market-timing efforts are far more likely to add unnecessary costs and/or unwarranted risks than to improve your returns.
This is powerful stuff to build on. In 2014, Fama and French published a five-factor asset pricing model, which now explains nearly 100% of the cross-section of expected returns. Whether returns among different portfolios can be explained by three or five factors, your evidence-based strategy deserves your confidence and commitment. If your investment portfolio were a house, your particular allocation to value stocks is an essential, load-bearing wall. It should not be abandoned lightly.
Next up, we’ll help you put a 10-year underperformance record for any given stock market factor – including value stocks – into appropriate, evidence-based context. We’ll also address why there’s solid evidence that the best is yet to come.