Value investing: Can you withstand the pain?

/Value investing: Can you withstand the pain?

Value investing: Can you withstand the pain?

By | 2017-08-18T16:53:46+00:00 July 31st, 2014|Research Insights, Value Investing Research|15 Comments
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(Last Updated On: August 18, 2017)

So the market took a tumble today–Feeling pain? Feeling emotional? Expecting the downward trend to continue?

Be careful, your system 1 is terrorizing your ability to make effective decisions.

To put a -2% day in perspective, let’s review some history related to value investing…

Defining a simple value investor

We define a value investor as one who buys low-priced stocks.

Being a value investor has the intuitive appeal of “buying cheap stuff.”

Additionally, numerous academic papers have shown the persistence of the “value” premium, which Fama and French famously documented in their 1992 JF and 1993 JFE papers.

So why isn’t everyone buying cheap stocks?

Being a value investor requires some patience and faith that market overreactions will eventually be corrected.

In theory, value investing is easy: buy and hold cheap stocks for the long haul.

In practice, value investing IS ALMOST IMPOSSIBLE.

Using Ken French’s data, we examined some time periods where it was painful to be a value investor.

One such period is during the run-up to the internet bubble. We examine the returns from 1/1/1994-12/31/1999 for a Value portfolio (High B/M quintile, VW returns), Growth portfolio (Low B/M quintile, VW returns), Risk-Free return (90-day T-Bills), and SP500 total return.

2014-07-29 15_43_16-Microsoft Excel - EQV_including_dispersion_analysis_v01.xlsm

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Talk about a beat-down! Looking at the annual returns, value investing lost every year to a simple market allocation!

2014-07-29 15_45_59-Microsoft Excel - EQV_including_dispersion_analysis_v01.xlsm

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Looking back, we now realize that the internet bubble was about to burst, but at the time, value investing was getting criticized.  Warren Buffett, arguably the greatest value investor, was criticized in the media for “losing his magic touch.” After the fact, it is obvious that value works, but truly ask yourself:

COULD YOU STICK WITH AN INVESTMENT THAT LOST 6 YEARS STRAIGHT TO THE MARKET?

If you did have the discipline and commitment to value investing you were rewarded.

Here are the returns to the same portfolios from 1/1/2000 – 12/31/2013:

2014-07-29 15_58_14-Microsoft Excel - EQV_including_dispersion_analysis_v01.xlsm

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

For the next 14 years, value investing was the better bet (we have documented this before).

Here are the results over the entire time period from 1/1/1994 – 12/31/2013:

2014-07-29 16_01_28-Microsoft Excel - EQV_including_dispersion_analysis_v01.xlsm

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

So while over the entire time period, value investing was optimal, there can be long periods of time (up to 6 years!) where you underperform.

Ask yourself again–and be honest:

Can you withstand the pain of value investing?

Said a different way:

Can you lose for 6 years and stick to the program?

Most of us simply cannot suffer that amount of pain as individuals. And for those of us in the investment advisory business, peddling a strategy with the potential for multi-year underperformance is akin to suicide (and yet, this is exactly what we do as value investors…maybe we need to check ourselves in to the asylum!)

A -2% day? A big deal? Well, things can get a LOT WORSE!

There is one person who can stick with the program and he’s smiling all the way to the bank!

 

 

 


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About the Author:

Jack Vogel, Ph.D., conducts research in empirical asset pricing and behavioral finance, and is a co-author of DIY FINANCIAL ADVISOR: A Simple Solution to Build and Protect Your Wealth. His dissertation investigates how behavioral biases affect the value anomaly. His academic background includes experience as an instructor and research assistant at Drexel University in both the Finance and Mathematics departments, as well as a Finance instructor at Villanova University. Dr. Vogel is currently a Managing Member of Alpha Architect, LLC, an SEC-Registered Investment Advisor, where he heads the research department and serves as the Chief Financial Officer. He has a PhD in Finance and a MS in Mathematics from Drexel University, and graduated summa cum laude with a BS in Mathematics and Education from The University of Scranton.
  • Michael Milburn

    Nice post. If I may opine, I think psychologically the way WB separates intrinsic value from market value is key to hanging in there. He’s not really buying what we often call value based on metrics, but he’s buying earnings and equity predictability into the future. (He had some bad situations early on w/ some value companies – even the original Berkshire itself – and that seems to have shaped his preference for predictability vs. just buying cheap companies.)

    fwiw, I’m always fishing around for new ideas, so I doubt I’d stick solely w/ a strategy that underperformed for so long. But I will say I’m very interesting in the combination 50%value 50% momentum approach that I’ve recently become aware of based likely on links and conversation on this site among others (especially the risk reducing effects due to low correlation of the strategies).

    I was recently reading about O’Shaugnessy’s Trending Value strategy of screening first for value, and then subsequently purchasing momentum stocks from the survivors. Are there other studies of this nature that compare the value/momentum approach to a pure momentum approach? I guess I’m trying to determine whether blending value w/ momentum is helpful, or whether restricting momentum approaches to value stocks actually hurts returns (like trying to mixing oil and water) and if I’d just be better w/ 50% pure value, and 50% momentum instead of trying to blend value and momentum in a single strategy?

    Based on a comment from Wes earlier I gather that he prefers to keep value and momentum approaches pure. When he discusses not buying expensive stocks ever – he seems to be in pure value mode (doesn’t mix momentum ideas), and when he says “ride winners and cut losers” he doesn’t discuss valuation. In practice, momentum strategies will have some expensive stocks, and value strategies will some poor momentum. My natural inclination is to say combine both ideas into a single quadrant of value stocks w/ momentum, but there’s alot of reasons to wonder if that’s helpful or defeatist compared to the pure approaches. Are there any studies breaking stocks into a) Value + Momentum b) Value + No-mentum, c) No Value + Momentum, d) No Value + No-mentum that could inform my thinking?

    I apologize if this is obvious and well known material, but I’ve searched google w/ limited success, and I’m not an academic so I’m unfamiliar w/ whether this is well known or not. While I have software that can test momentum strategies, I don’t have ability to combine fundamental data w/ price trend data. Appreciate any pointers if there’s a good summary study on this is available. (or if O’Shaughnessy’s study is pretty much definitive).

    I appreciate this blog. Good stuff.

  • There is a ton of research on value and momentum. Here are 2 good ones to kick it off:

    http://technicalanalysis.org.uk/momentum/Asne97.pdf
    https://noppa.oulu.fi/noppa/kurssi/721383s/materiaali/721383S_value_and_momentum_everywhere.pdf

    Bottomline: mixing value and momentum has worked historically…

    I prefer the pure play value or momentum because it is easier for assessing performance after the fact and it allows you to focus the R&D effort. Our goal is to find the BEST pure value system and the BEST pure momentum system. How people allocate to value and momentum is up to personal preference and portfolio construction.

    But is “pure play” the only way to go? Of course not. You could also do value systems with elements of momentum or momentum systems with elements of value. In the end you’re going to be capturing returns associated with cheap stocks and trending stocks…how you slice and dice the pie probably won’t matter in the end.

    Despite popular opinion, quant system design does involve some element of art–but a minimal degree…don’t want to get those behavioral bias too fired up!

  • Michael Milburn

    Wes, thanks for the links. I will read them. I think I understand why you want to isolate value and momentum. My interest stems from the inclination that value might be one universe, momentum might be another universe, and a value/momentum blend might be a third, mostly distinct, non-overlapping universe on the frontier. It seems it’s possible that a value/momentum blend – even though we call it a blend – might actually be it’s own “pure play” mostly selecting from a different pool of stocks. (at least the blend it seems to turn up several different stocks when I put together some rankings).

    Jack Vogel’s post above got me to thinking about psychological elements again, and coming from that standpoint I think I’m wired to withstand more pain w/ value stocks – or at least value stocks that have “quality” to them – simply because I have confidence that they have staying power. I admit that it’s tougher to just trust momentum on it’s own, so my desire to integrate value is psychological – it’s uncomfortable to pull the trigger on some of the high multiple momentum stocks (or no multiple). But that might be part of why it works.

    I appreciate the links.

  • Michael Milburn

    still absorbing the Asness paper (thanks for the link – I’d have never found that myself), but based on the results I can see why it’d make sense to just focus on momentum. Value filtering doesn’t have much of an impact on returns in the highest momentum quintile.

  • Agree that you could get potentially get a unique system with a blend…

  • Michael Milburn

    Wes, do you know if there’s a lot of quantitative shorting of the expensive+low momentum stocks like Asness describes in his paper to capture the spread in a long/short portfolio? I’m just trying to think about technical factors why some stocks that get in a bad trend stay down for a long time, and amplifying effects.

  • Not really. We’ve tried in the past and determined early on that shorting expensive and/or low momentum stocks is a great way to get your face ripped off. Plus, rebate fees are expensive and it is operationally intense to short…not to mention tax inefficient.

    All these long/short results presented in academic papers should be taken with a massive grain of salt–most of the “alpha” comes from an inconceivable short side portfolio. The stats look great, but in real-life you’d die trying to get the dreamy statistics.