Editor’s Note: The ability of value investors to adhere to their investment strategy has been put to the greatest test ever. From January 2017 through March 2020, in terms of total returns, the Russell 3000 Growth Index outperformed the Russell 3000 Value Index by 51.7 percentage points (46.7% vs. -5.0%). That drawdown was much greater than previous ones and has lasted longer. For frequent readers of the blog, we’ve made this dirty little secret fairly obvious. A quick search of our inventory of articles turns out a bevy of results, including “Is Systematic Value Dead???,” “Is value dead? Has the story changed? No,” “Is There Something Wrong with the Value Premium?” and many more to keep you reading for days. Writing/reading about the realities of the value premium can help build our ability to stay disciplined (if an investor chooses to go down the value path). We hope this piece contributes to this cause. Two of legendary investor Warren Buffett’s great contributions have been that he has taught investors to buy cheap, profitable companies and that he has preached the importance of patience and discipline, avoiding the noise of the market. He famously said, “Investing is simple, but not easy.” Or as Wes put it, “Even God Would Get Fired as an Active Investor.” If his strategy of buying profitable value stocks is simple, why did he proclaim it is not easy? I believe it is because he understood that all strategies that invest in risky assets experience long periods of poor performance. And most investors are unable to withstand the stress created by such periods. At some point, the drawdown, whether it’s in absolute or relative terms, becomes large enough that it causes investors to reach what I call their “GMO” point—the point where their stomach screams, “Get me out!” That leads to the loss of discipline and panic selling, which is why Buffett has advised investors: “If they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful.” In other words, buy after long periods of underperformance and sell after periods of outperformance! Unfortunately, that is exactly the opposite of what so many investors do. Examining the historical evidence on drawdowns demonstrates how important it is to stay disciplined, adhering to your investment strategy. As you review the evidence, keep in mind Buffett’s warning about trying to time the market. And remember that if active managers were able to time their exits and entrees, we would see persistent evidence of their ability to outperform. However, we don’t have any such evidence. We’ll begin by reviewing the evidence on the riskiness of equities. To appreciate the riskiness of equity investing, consider that while from 1926 through July 2020 the S&P 500 Index returned 10.2% per year, it did so while experiencing volatility of 18.7%. In addition, it experienced six crashes of at least 33%:
- September 1929-June 1932 (loss of 83.2%).
- April 1937-March 1938 (loss of 49.7%)
- January 1973-September 1974 (loss of 42.6%).
- March 2000-September 2002 (loss of 38.3%).
- June 2007-February 2009 (loss of 50.0%).
- February 4, 2020-March 23, 2020 (loss of 33.8%).
- Even the investments that created the most wealth for shareholders during a given decade experienced very substantive reversals along the way—within the highly successful decade, shareholders experienced drawdowns that lasted an average of 10 months and involved an average loss of 32.5%.
- During the immediately preceding decade, drawdowns for these highly successful stocks lasted an average of 22 months and involved an average cumulative loss of 51.6%—you had to stay the course, enduring those dramatic drawdowns to make sure you were still there to experience the great returns.
The Wild Ride of the Value Premium
- 1931-32 value drawdown was 30.8%.
- April 1937-May 1940 value drawdown was 36.4%.
- August 1979-November 1980 value drawdown was 28.3%.
- April 1989-December 1991 value drawdown was 25.0%.
- June 1998-March 2000 value drawdown was 36.6.
- After underperforming growth by 16.8% per annum (total drawdown of 30.8%) from 1931 through 1932, from 1933 through 1936 value outperformed growth by 14.1% per annum (total outperformance of 93.5%).
- After underperforming growth by 13.3% per annum (total drawdown of 36.4%) from April 1937 through May 1940, from June 1940 through December 1949 value outperformed growth by 10.7% per annum (total outperformance of 165.9%).
- After underperforming growth by 22.1% per annum (total drawdown of 28.3%) from August 1979 through November 1980, from December 1980 through December 1988 value outperformed growth by 10.7% per annum (total outperformance of 133.6%).
- After underperforming growth by 22.0% per annum (total drawdown of 36.6%) from June 1998 through March 2000, from April 2000 through December 2006 value outperformed growth by 14.2% per annum (total outperformance of 145.3%). 1
SummaryAll strategies involving risk assets assume risk of failure, regardless of your investment horizon—there is no guarantee that you will ultimately be rewarded. If you doubt that, just ask investors in Japanese large-cap stocks, who from January 1990 through March 2020 earned no return, and that’s even before considering inflation (note that value stocks returned 3% per annum). That’s not a reason to avoid risk. It’s a reason to diversify, avoiding the concentration of assets in any one risk basket, because that basket just might be the one that experiences decades of underperformance. As mentioned earlier, the S&P 500 has experienced three periods of at least 13 years when it underperformed totally riskless Treasury bills—another example of why investing is simple, but not easy. In my 25 years of advising both individual and institutional investors, the biggest mistake they make is thinking that when it comes to judging the performance of an investment strategy, three years is a long time, five years is a very long time, and 10 years is an eternity. That belief leads them to ignore long-term evidence and abandon well-thought-out plans in order to chase performance. The result is that they end up buying high (after periods of outperformance) and selling low (after periods of poor performance). Buying high and selling low is not a prescription for success. Yet, it is the path so many investors follow when they fail to pay attention to the lessons history has provided. To paraphrase Spanish philosopher Santayana: “Those who don’t know their investment history are condemned to repeat it.” As Warren Buffett noted, when it comes to investing, once you have ordinary intelligence, temperament—the ability to ignore the noise of the market—trumps intellect. Do you have the discipline and patience to follow Buffett’s advice?
- For those not invested in the value premium 2000 – 2010 was known as the lost decade ↩