2nd Quarter Client Note – Tribulations of a Value Investor

Stock markets around the globe had their best first six months in years. In the second quarter, The S & P 500 (total return) Index gained 3.09%; bringing the total increase to 9.34% thus far for the year. US Large Cap Growth Stocks returned 4.67%. While Large Cap Value returned only 1.34%.

After years of persistent underperformance, international stocks are finally outperforming; though largely on account of the falling US Dollar, which had its worst performance in six years during the first half, falling by 5.6%. In the quarter, the MSCI World (ex USA) (net dividends) Index returned 5.63%. Emerging markets – still relatively cheap on a price/earnings basis compared with US stocks – gained 6.27%.

Interest rates were generally mixed; with short term rates rising slightly and intermediate and long term rates falling a bit. The return on the Barclays US Aggregate Index was 1.45% for the quarter and 2.27% for six months.

You can find all the data packed into the Quarterly Market Review from or friends at Dimensional Funds Advisors (DFA) – including an instructive essay about the relationship – or not – between rising interest rates and stock returns.

Speaking of DFA; one of the major developments of the quarter was the joint announcement of a strategic relationship between DFA and TD Ameritrade Institutional (another of our good friends)  – lowering transaction fees at the custodian on DFA funds from $24.99 per trade to $9.99 per trade. We are always cognizant of the costs of portfolio management. This welcome news will both lower the cost of rebalancing in larger accounts and allow certain smaller accounts to be economically invested utilizing DFA’s funds. Touché.

Value Stinks

Over the past decade, the Russell Growth Index has outperformed the Russell Value Index by 3% annually. While these stretches are not unusual, this is beginning to test even the most patient of value investors. Of course, patience wouldn’t be a virtue if it didn’t require occasional – or even persistent – testing.

Academic literature – along with supporting data – suggest that over long time horizons value stocks have historically outperformed growth stocks and that a “value” premium may exist for investors who choose to emphasize or overweight such stocks in their portfolios. A working definition of value is simply: stocks which are relatively less expensive based upon one or more formulas – with price as the numerator and something like book value or earnings in the denominator.

The literature ascribes two possible explanations for the premium. First is risk. Many of these companies are troubled and deserve to be underpriced. Value investors understand that some of these companies will be turned around by their managers and the market will reward their patience with higher than average returns. The second explanation is behavioral. Other investors are impatient and chase the returns of so-called glamour stocks irrespective of whether those stocks may become massively over- priced.

For value investors, price matters. So, while not completely eliminating growth stocks from our portfolios – after all, these companies do contribute positively to expected return – we under-weight them relative to the market and over-weight the value stocks.

However, while the odds of realizing the value premium (shown to be approximately 4.5% over the period from 1927 – 2015) are reasonably strong over long time horizons (think 10 or 20 years) there are also long periods of underperformance.  And we are in one of those periods now.  To be a successful value investor you need to have tolerance for what we call “tracking error” – the fact that your portfolio may zig while your neighbor’s zags.

What about Timing?

So why don’t I just invest in growth stocks when they are outperforming and in only value stocks when they are having their day in the sun? Glad you asked. The answer is because the evidence indicates that forecasting the emergence and retraction of the value premium is virtually impossible.

How Can Portfolios DeFANGed?

A small number of growth stocks has accounted for an overwhelming portion of the entire return of the S & P 500 Index. These are the so-called FANG stocks: Facebook, Amazon, Netflix and Google. FANMAG, if you add Microsoft and Apple. These six stocks alone have accounted for more than half the gain in the index. Their earnings are growing rapidly. Their prices even more so. The six stocks boast a weighted average P/E of 56 – more than twice the P/E of the index.

Consequently, because the index is weighted by market capitalization, these few companies make up an increasing proportion of the market value of the entire index. This inadvertent concentration goes against the grain of diversification; and makes what is supposed to be a core holding (i.e., fairly neutral as between growth and value) look more like a growth fund. Granted, these are great companies. But their valuations are worth questioning.

The risk is that companies miss their earnings expectations and fall as fast – or faster – than they went up; as jittery investors head for the exists. It is easy to get carried away. The downside of not rectifying this may outweigh any future return advantages. It pays to remember the Nifty Fifty from the early seventies and the tech bubble of 2000, in the aftermath of which value dramatically outperformed.

Slice and Dice?

One way to attack this risk is to accompany your core (hopefully indexed) holding with some dedicated large cap value and small cap value sleeves (say 5% or 10%) and periodically rebalance back to your strategy weights. For example, you might own Vanguard Total Market Index Fund (VTSMX) – the quintessential core building block – as it contains 3,568 holdings representing the entire market – in exactly their market capitalization weights.  And pair it with both Vanguard Value Index(VIVAX)  and Vanguard Small Cap Value Index (VISVX). This would be like owning an SUV, a sedan and a sports car; using them for their intended purpose – but making sure you don’t put too much mileage on any one of them.

Highlight – DFA Core Strategies

Another way is to have the engineers do all of the rebalancing under one hood. More like owning a luxury sports sedan. DFA US Core Equity 1 (DFEOX) is such a vehicle – but far less expensive than a Mercedes S550 – only 19bps. Like Vanguard Total Market Index Fund, DFEOX – with 2600 holdings – represents the total US stock market. But when you look under the hood of DFEOX you see a fund tilted toward value and small cap stocks; with those tilts maintained by the portfolio managers even in an environment where large cap growth stocks outperform over a long period of time and would otherwise comprise increasing weights in the fund.

DFEOX’s holdings have an average market capitalization of $30 billion; compared with $50 billion for VTSMX. (Interestingly, Morningstar’s Large Blend category average is $110,000 billion – meaning active fund managers are really chasing growth stock returns and are in fact significantly overweight the priciest stocks.)

VTSMX contains 75% of its holdings in large cap stocks and 25% in mid and small cap stocks. While DFEOX contains just 56% of its holdings in large cap stocks and 44% in mid and small cap stocks.

What you also notice in DFEOX is generally smaller weights of FANMAG (with Apple being a slight exception):

_                           VTSMX                  DFEOX

AAPL                     3.00%                   3.08%

MSFT                     2.02%                   1.65%

AMZN                    1.59%                   1.52%

GOOGL  (A&C)        2.28%                   1.16%

FB                          1.41%                   .91%

Bad with the Good

There’s no guarantee of course that history will repeat and that value will again ultimately prevail. But as Herb Stein (Nixon’s chief economic adviser and Ben Stein’s smarter father) once said: If something cannot go on forever, it will stop.

Whatever your specific approach to value investing, the key is that once you’ve committed to being a value investor you need to stick with the strategy; lest you wind up committing the Cardinal sin; buying high and selling low. As David Booth, the founder of Dimensional Funds recently quipped in response to the question: How long do I have to wait for an investment strategy to pay off? At least one year longer than you’re willing to give.

Bigger Picture

The eighth year of a bull market begs bigger questions than the growth vs value conundrum. Namely: Does your low-cost globally diversified portfolio still reflect your goals as well as your need and ability to accept risk? Are you prepared for lower future returns and the inevitable market downturn? Nobody knows whether this is the beginning of the end of the bull market or just a taste of greater things to come. But now may be the perfect time to take a good look at the question of whether your portfolio is tuned correctly for your personal road trip. Give us a call and let us know how we can help.

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