Willow Creek Commentary: Summer-2019

WILLOW CREEK AND THE VALUE PREMIUM

Willow Creek Wealth Management adheres to a disciplined, evidence-based approach to our investing. One of the core elements to this approach is the conviction that value stocks (think companies that are currently out of style with the market) will generate higher returns than growth stocks (companies that are seen as popular but expensive) for our clients over the long-term. Historically, value stocks have outperformed growth stocks by 3.3% per year over the period of 1928–2018.

But it’s also no secret that the value premium has been hiding for quite a while. Globally, value stocks have been under performing relative to growth stocks for over a decade. Are the underwhelming returns a temporary bump in the road, or does it represent a new reality for value stocks?

 

A LITTLE BACKGROUND

Our evidence-based approach was developed by professors Eugene Fama and Ken French, who suggested three sources or “dimensions” of expected returns could explain almost all of the differences in returns among different portfolio builds:

  1. The equity premium – Stocks (equities) have returned more than bonds (fixed income).
  2. The small-cap premium – Small company stocks have returned more than large-company stocks
  3. The value premium – Value company stocks have returned more than growth company stocks. Value companies are those that appear to be under- valued by the market, relative to growth companies.

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 only returned 5%.  

To put it 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. Almost any other stock-picking or market-timing effort is far more likely to add unnecessary costs and/or unwarranted risks than to improve your returns.

 

THE INVESTOR’S LONG HAUL

A decade is a long time to tolerate disappointing numbers, while awaiting an expected reward. However, as is the case for any other source of expected investment returns (including the equity premium itself), we evaluate value stock performance over a decade or more, since the expected outperformance can go into hiding for years on end – and often has.

A ‘disappearing’ value premium, even over a 10-year stretch, is nothing new. In fact, since the late 1970s, 27% of all rolling 10-year periods have seen a negative value premium. Of course, on the flip side, this means 73% of them delivered a positive premium. These seem like pretty good odds to us.

Also consider, when a source of expected return does resurface after a hiatus, it’s often in the form of an exuberant leap nobody saw coming, except in hindsight. For example, growth stocks had outperformed value by 2.1% annually for the decade ending October 2000. Then, abruptly, the tables turned; value bested growth by 35% over the next five months. Based largely on this single surge, value ended up outperforming growth by 2.4% for the 10 years ending May 2001

In short, only those who can tolerate the doldrums tend to still be around to reap the unpredictably timed windfalls that often dramatically impact your long-term returns. Value investing is not dead; it is just waiting until many value managers lose their hair and capitulate.

 

POPULARITY CONTESTS AND FUTURE EXPECTED RETURNS

There has been recent speculation that value investing has fallen victim to its own success. As more investors have incorporated the value factor into their portfolios, has old-fashioned supply-and-demand eliminated the expected return premium? We don’t know for sure, but we don’t think so. It’s more likely that investors who cannot tolerate the recent underperformance are unwittingly setting the stage for the value factor’s comeback.

Think about it: Whenever one investor wants to sell their shares, somebody else has to buy them, or the transaction cannot occur. As some investors waiver and sell their value stocks at lowered prices, other bargain-hunting buyers swoop in and position themselves for future expected growth. Eventually the pendulum is likely to swing, and the cycle begins anew.

That’s how efficient markets have worked for decades, if not centuries. It’s how they’re expected to continue to work moving forward. In other words, in an ironic twist, lower current prices actually suggest higher future returns.

Value is currently trading at the biggest discount ever and offers the largest expected return premium over the last 30 years (and by this we are referring to future, not current expected premiums). In other words, for those who stick with the value factor, solid evidence remains that the best is yet to come.

 

WHAT MATTERS IN THE END

So, where does this leave us? We remain confident that the value premium is far more likely slumbering than gone. Unfortunately, nobody can predict when it will awaken, or whether it will do so gradually or in a rush.

For better or worse, this is the nature of market risks and their inherent expected rewards.

By spreading your risks across multiple sources of expected returns (i.e., asset classes), you can better manage the very real risks involved in pursuing them. In the frightening face of uncertainty, patient resolve and objective evidence are your greatest guides.