September, 2022
A frequently voiced argument against value investing stems from opinions expressed in the media and elsewhere that we’re in a “new normal” environment where stocks in innovative or high-tech companies have an investing advantage over “old guard” established industries, such as energy or financials.
Until recently, FAANG stocks were a poster child for this argument; those behemoth technology companies have contributed substantially to much of the market’s overall return during the last decade. By virtue of their status as growth stocks, they even caused negative value premiums to occur. From January 2010 to December 2020, the five FAANG stock outperformed the Russell 3000 US Market index by 13.6% a year! Who wouldn’t want that?
However, from January 2021 to December 2021 we find that FAANG outperformance over the Russell broad US market index reduced to only 3.3%. Recently, from January 2022 to the end of June 2022, Netflix declined 71.0% and Meta (formerly Facebook, the “F” in FAANG with Netflix as the “N”) declined 52.1%. Amazon declined 36.3% and Google dropped 24.7%. Nobody wants that.
Consequently, during their annual reconstitution event, Russell reclassified mega firms Meta and Netflix from “growth” to “value.” It’s ironic that 40% of the pillars used to support media growth arguments inimical to a value investing approach have now metamorphized into value stocks themselves.
This highlights a common misconception about the character of “value investing.” A “value premium” is best understood as the discount-rate relative to business financing. Expected cash flows for all companies over their likely futures, as reflected in constantly changing market prices, are not identically discounted. Firms with stock prices low relative to their expected future cash flows tend to have higher expected returns for investors willing to hold their shares. This is not true of FAANGs.
Those emphasizing the advantages of investing in expanding growth firms, such as FAANGs, inadvertently are making a case for applying a lower discount rate for those firms’ expected cash flows. All else being equal, such as with soaring FAANG stock prices, greater certainty around continued company success should be associated with lower expected returns for investing outcomes! Those seeking better opportunities for high returns on their capital will be turning their attention elsewhere since all that good news is in the price of those shares. That a big drop in FAANGs finally occurred, triggered by unexpected bad news, is not surprising based on capital market theory.
Exhibit 1 shows that for companies which have grown to become among the largest based on market capitalization, once positioned within that group, should be expected have much lower future market returns (on average), more aligned with the broader market indexes. Thus, those forecasting perpetually good future returns due to past company success, should reconsider whether equating the company growth they expect with high stock returns going forward is sensible.
Exhibit 1: What Have You Done for Me Lately?
Average outperformance of companies before and after becoming one of 10 largest
In USD. Data from CRSP and Compustat for the time period 1927-2021. Average annualized outperformance of companies before and after the first year they became one of 10 largest in US. Companies are sorted every January by beginning of month market capitalization to identify first time entrants into the top 10. Market defined as Fama/French Total US Market Research Index, a value-weighted US market index sourced from CRSP, dividends reinvested in paying company until portfolio is rebalanced. The Fama/French Indices represent academic concepts that may be used in portfolio construction and are not available for direct investment or for use as a benchmark. Index returns are not representative of actual portfolios and do not reflect costs and fees associated with an actual investment. Index has been included for comparative purposes only. Compared to Fama/French Total US Market Research Index, 1927–2021. Past performance is no guarantee of future results.
Volatile Markets Don’t Help Active Managers
Active managers frequently claim that they do best in times of high market volatility. This may sound like an emotional hedge akin to having its payoff for betting against your favorite sports team. However, a careful study of active US-domiciled equity funds finds no meaningful relation between market volatility and an improvement in managers’ success rates. Rather, it appears that traditional active investing actually compounds concerns in bad times.
The rolling three-year standard deviation for US stock market returns, illustrated by the orange line in Exhibit 2, shows recent volatility at its highest level since the 2008 global financial crisis. The rolling three-year outperformance rates of active US equity funds (blue bars, notably almost all much less than 50 percent) imply very little relation with volatility levels. The high year-to-year variation in success rates does not consistently track market volatility. For example, rolling averages of daily volatility from 2014 to 2019 were level, yet the percent of funds outperforming during these rolling periods was not, ranging from 23% to 37%. We doubt those outcomes will improve going forward.
Exhibit 2: Active Imaginations At Work
Rolling three-year outperformance rates for active US equity funds vs. stock market volatility January 2005 – December 2021
Market volatility computed each month using standard deviation of Fama/French Total US Market Research Index daily returns. Monthly volatility observations are then averaged over rolling three-year periods formed at the end of each year. Outperformance rates are computed over the same rolling three-year periods and are calculated as the percentage of active US-domiciled equity funds that survive the period and outperform their respective Morningstar category index net of all fees and expenses. Sample of active managers consists of funds categorized as active US equity by Morningstar. Fund returns are average returns computed each month, with individual fund observations weighted in proportion to their assets under management (AUM). Index benchmarks are those assigned by Morningstar based on the fund’s Morningstar category. Past performance is no guarantee of future results.
Confidence in Your Planning
Volatile market environments cause enough worries – erratic outcomes only add to them. Traditional managers and quants always make predictions or back test simulations. Dimensionally structured strategies don’t try to outguess markets and are not constrained by arbitrary index parameters. Instead, we rely on information in market prices, and apply a scientific, transparent, and process driven approach that systematically pursues higher expected returns in our portfolios with low-cost, diversified solutions. By closely aligning your personal retirement income and legacy goals and preferences with your investing, you can have much greater confidence in outcomes you plan for tomorrow, and the greater your family’s peace of mind can be today.