Swedroe: Discipline Trumps Distraction

October 09, 2017

Having a well-thought-out investment plan is the necessary condition for successful investing. However, it’s not sufficient.

The sufficient condition is having the discipline to stay the course during the virtually inevitable periods when a strategy underperforms. That, of course, is why Warren Buffett once advised investors that “the most important quality for an investor is temperament, not intellect.”

Unfortunately, it’s my experience that, when contemplating investment returns, the typical investor considers three years a long time, five years a very long time and 10 years an eternity. However, financial economists know that when it comes to the returns of risky assets, periods as short as three or five years, or even 10 years, should be considered nothing more than noise.

No more proof is required than the fact that over the nine years ending in 2008, the S&P 500 Index underperformed riskless one-month Treasuries by a compound 6.7% a year, a cumulative underperformance of 59%. It underperformed five-year Treasuries by 10.8% a year, a cumulative underperformance of 115%.

Factors Hold Up

Investors in stocks should not have lost faith in their belief that stocks should outperform safer Treasuries due to that experience. And most didn’t.

Yet when small stocks, or value stocks, underperform for a few years, as value stocks did from 2008 through 2015 (they underperformed growth stocks by 2% a year, or a cumulative 16%), they begin to question their diversification strategy and lose discipline.

Value’s extended period of poor performance has led many to question whether the publication of academic research on its premium, along with the strategy’s ensuing popularity, brought about cash flows which may, in turn, have resulted in the premium being arbitraged away.

To test this hypothesis, David Blitz, author of the February 2017 paper “Are Exchange-Traded Funds Harvesting Factor Premiums?”, analyzed the factor exposures of ETFs and found that “for each factor there are not only funds which offer a large positive exposure, but also funds which offer a large negative exposure towards that factor.”

He also found that “on aggregate, all factor exposures turn out to be close to zero [ranging from -0.03 to 0.03], and plain market exposure is all that remains.”

Blitz writes: “This finding argues against the notion that factor premiums are rapidly being arbitraged away by ETF investors and also against the related concern that factor strategies are becoming ‘overcrowded trades.’”

Valuations Matter

Sophisticated investors know that, over the long term, equity returns tend to exhibit mean reversion. This occurs because periods of poor (strong) performance typically end with valuations at lower (higher) levels, forecasting higher (lower) forward-looking return expectations.

With that in mind, I will examine the current valuations of U.S. value stocks, specifically their P/E and BtM ratios, to see if they are relatively cheap (which research has found predicts a higher value premium in the future) or relatively expensive (which predicts a low or nonexistent premium going forward).

To determine if value is now relatively expensive or relatively cheap, I’ll compare today’s valuations with those from 1994 (before the growth bubble began later in the 1990s).

But first, the value premium was 5.5% from 1927 through 1994. It turned highly negative (with a -19% cumulative return) from 1995 through the first quarter of 2000. The high valuations of growth stocks in March 2000 led to value’s best historical performance over the next seven years, with an annual premium in excess of 15%.

At the end of 1994, the BtM ratio of U.S. large growth stocks was 0.4 and the BtM ratio of U.S. large value stocks was 0.85. Thus, from a BtM perspective, large growth stocks were 2.12 times as expensive as large value stocks.

The P/E ratios were 15.8 for large growth stocks and 10.3 for large value stocks. Thus, from a P/E perspective, large growth stocks were trading 1.53 times as expensively as large value stocks.

At the end of 1994, the BtM ratio of U.S. small stocks (the data I had available defined small stocks as CRSP deciles 9-10, or what would be considered microcaps) was 0.61, and the BtM ratio of U.S. small value stocks (with small stocks in this case defined as CRSP deciles 6-10) was 0.93.

Thus, from a BtM perspective, small stocks were trading 1.52 times as expensively as small value stocks. The P/E ratios were 14.1 for small stocks (CRSP deciles 9-10) and 11.7 for small value stocks (again with small stocks defined as CRSP deciles 6-10). Thus, from a P/E perspective, small stocks were trading 1.21 times as expensively as small value stocks.


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