July 20, 2015
[Editor’s note: Tim Price, London-based wealth manager and editor of Price Value International, is filling in while Simon travels to Europe.]
History and convention tell us that bonds are the ‘safest’ investments in the world.
Yet it is the crowning irony of the current financial situation that policy makers have made these traditionally safe assets the most unsafe investments in the world.
Western government bonds no longer offer any attraction, either in terms of income or capital preservation.
They are simply instruments of confiscation. They just haven’t yet been fully recognized as such.
That clearly leaves stocks as the preferred risk asset, by default (a relevant pun). But what sort of stocks?
History offers some useful clues.
James O’Shaughnessy in his book ‘What works on Wall Street’ conducted extensive research on common stocks in the US market.
And the most compelling strategy for delivering attractive long term returns came from value investing.
O’Shaughnessy analyzed a 3,000 stock universe over a period of 52 years.
For each year he identified the 50 most expensive and least expensive stocks by a variety of metrics. He then rebalanced that 50 stock portfolio each year, ensuring that only the most and least expensive stocks were retained.
If you had bought the 50 ‘growth’ stocks with the highest price / earnings ratio, for example, after 52 years, a portfolio with an initial value of $10,000 would have grown to $793,558.
That sounds like a decent return. Until you compare it with a portfolio comprising the 50 stocks with the lowest price / earnings ratio.
This ‘value’ portfolio, with an initial value of $10,000, would have grown to $8,189,182, over 10x as high.
If you had bought the 50 ‘growth’ stocks with the highest price / book ratio, the results were even more extraordinary. Your initial $10,000 would have compounded, over time, to $267,147.
But if you had bought instead the 50 ‘value’ stocks with the lowest price / book ratio, a portfolio with a starting value of $10,000 would have grown to be worth $22,004,691– over 80x as high.
A period of 52 years is a statistically meaningful period of time. The O’Shaughnessy study strongly suggests that over time, ‘value’ completely trumps growth.
A bias to ‘value’ may not work every year, but it’s unlikely that any strategy will work without fail year after year. There will always be good years and bad years.
‘Value’ investing requires patience, an attribute that many investors frankly lack.
The larger problem today is that many traditional markets are expensive.
Robert Shiller’s cyclically adjusted price / earnings (CAPE) ratio for the S&P 500 index, for example, currently stands at 27.3. Its long run average is 16.6.
On a CAPE basis, the US stock market realistically has only been more expensive twice in history– once in 1929, and once in early 2000, both years of spectacular busts.
Aldous Huxley once wrote, “That men do not learn very much from the lessons of history is the most important of all the lessons of history.”
The history is very clear about the benefits of investing in the waters of deep value. And it is similarly clear about the dangerous of buying into overpriced markets.
One can only hope that Mr. Huxley was wrong.