Mr. $74 billion
Have hot Nasdaq NDAQ giants gotten too hot? Maybe its time for small, boring companies to catch up.
It has been a glorious time for big, glamorous companies. The Vanguard Growth fund, which owns favorites like Microsoft MSFT , Amazon AMZN and Tesla TSLA , has delivered a 25% return over the past year.
It has been a rotten time for small and uninteresting companies. The 12-month return for Vanguard Small-Cap Value, which mostly owns slow-growing outfits that you have never heard of, is -15%.
You expect value companies to go in and out of favor and small companies to go in and out of favor. Either could beat or lag the market a little. But this is a 40-point differential. The divergence in returns between large growth and small value is freakish.
It is possible that big growth stocks have gotten too expensive and small value stocks too cheap. If you want to make a bet that this is the case, you would move money out of big growth stocks and into the shares of small companies trading at low multiples of earnings or book value. Youd be fighting the tape. But you might be vindicated in a big way over the next several years.
Fair warning: Fans of value investing, myself included, have been predicting its resurgence for quite a while, and have come away disappointed time and again. Research Affiliates, a money manager in Newport Beach, California, sums up their despair in a recent white paper. Value has been underperforming growth since 2007, says the report, an extraordinarily long losing streak.
Only part of this underperformance is related to the earnings disappointments of value companies like oil producers. Most of it, say the papers authors (among them, RA founder Robert Arnott), can be blamed on the ever-larger premiums the market bestows on growth companies. Indeed, the disparity in valuation between growth and value is at an historical extreme, near the 100th percentile level.
No question that Tesla deserves to be trading at a higher multiple of its book value than Bank of America BAC . But how much higher? The price/book ratios for these two are 27 and 0.9. Quite the spread.
At some price point good companies cease to be good investments, and unattractive companies cease to be bad investments. The Research Affiliates analysis suggests that we have reached that point, that its time to favor value.
The size factor, another driver of stock market performance historically, is also acting out of character. Over long stretches in the past century, small-company stocks have beaten big-company ones. But that pattern is now disrupted. In the past decade small stocks have lagged the big-company S&P 500 index.
Time for the little stocks to catch up? Research Affiliates thinks so. The market seers there are a bit pessimistic about U.S. equities, but less pessimistic about small companies than big ones. They project an annual 4.7% return, including dividends, on small stocks (2.7% after inflation), 2.5% on big ones (0.5% after inflation).
The last 13 years have been utterly baffling to academic researchers, who thought they had it all figured out. There were certain factors, they theorized, that led to excess returns. Value was one and small size another.
For both of these factors, there was a persuasive explanation. It was possible for value stocks to do better than growth stocks over the long haul because investors, with vivid memories of stars like Amazon and not such lasting memories of flops like Webvan, overpaid for growth. The theory on the small stocks winning out over time is that they are risky and illiquid and so investors have to be rewarded for putting up with them.
Buy small, buy valueit worked for a long while. Kenneth R. French, a professor at Dartmouths business school and a prominent theorist about factor investing, publishes performance data for subsets of the market. In one of his tables the stock universe is carved into five subsets of size (measured by market capitalization) and five quintiles of value (measured by price/book ratios). Take a look at the stocks falling in both the smallest cap group and the highest value (lowest price/book) quintile. If you had bought these and constantly updated your portfolio you would have, in the span of 80 years ended in December 2006, turned $1 into $420,000.
On paper, that is. No one did this, and anyone who tried would have confronted bid/ask spreads cutting deeply into the supposed returns. (Those little value companies had tiny capitalizations, making it expensive to get in and out of positions.) Still, even allowing for the theoretical nature of this exercise, one concludes that there must have been something powerful going on with these size and value factors.
The 42,000,000% return comes to an annualized 17.6%, just about double the 9.4% seen in the diagonally opposite corner: big companies trading at high price/book ratios. A high price/book ratio doesnt equate to growth precisely, but its a good proxy. It would have meant buying Coca-Cola KO rather than some casket company.
And then, beginning in 2007, the tables turned. In the 13 calendar years since, big growth has walloped small value, 11.5% a year to 5.3%.
Maybe small values 80-year streak was a fluke, irrelevant to a digital economy. In which case you ignore it.
Or maybe theres something eternal at work, and small value is aching to reassert itself. There are two good ways to bet on this. Both are cheap funds, my favorite things to buy.
One is Vanguard Small Cap Value, ticker VBR. With this portfolio you are bypassing Amazon at 141 times annual earnings and Tesla at 217 times. Instead you own Sonoco Products SON , which costs 17 times earnings and is a leader in reels and spools. You own Steel Dynamics STLD , which costs 13 times and gets its dynamism from bundled scrap. You own 883 other stocks. Net of securities lending income, the funds expenses come to 0.02% of assets annually.
The other is a small-company fund with a more subdued tilt to value: Schwab Fundamental U.S. Small Company Index, ticker SFSNX. The index, designed by Arnotts Research Affiliates, weights 939 companies not by their market values but by a combination of three fundamentals: cash flow, sales and distributions (the sum of dividends and buybacks). Rather than exclude fast growers it just gives them a smaller spot than they would command in the usual market-value-weighted fund. Holdings include Range Resources RRC , a money-losing natural gas producer, and CoreLogic CLGX , a massager of real estate data. This funds expenses, net of sec lending, run to 0.19% annually.
Both of these funds failed to keep up with the bull market of the past decade. I expect them to outperform a weaker stock market in the coming decade.
Go here to read the rest:
Amazon And Tesla Versus 885 Cheap Stocks - Forbes
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