If you've read much about investing, you may have heard that value investing beats growth investing over the long run. Numerous studies have shown this in detail. Basically, buying low price to fundamental stocks beats buying high-flying, glamour stocks. But, that's not the whole story.
I was reminded of this, recently, when I was reading David Swensen's book, Pioneering Portfolio Management. Swensen has been managing Yale's endowment for almost two decades and has been generating great returns, so what he has to say should be taken quite seriously.
Swensen warns against just being a deep value investor. What he says is that deep value investing does great until the proverbial 100 year flood comes along. At that time, low price to fundamental stocks get crushed because they tend to be lower-quality, fundamentally riskier businesses.
Deep value investing works like this: poorly performing companies have very poorly performing stocks. People who buy these stocks at super-depressed prices (deep value investors) get great returns as long as the 100 year flood doesn't hit. In other words, they get great returns for bearing the risk of a flood as long as this isn't the year a flood comes. This makes value investors' records look extraordinary--until the flood.
When the flood hits, such portfolios get wiped out! Jeremy Grantham's (of GMO) research on how these investments did during the Great Depression is revealing. From 1929 to 1933, high price to book stocks (higher-quality, growth-oriented stocks) declined 84.3%. In contrast, low price to book stocks (lower-quality, value-oriented stocks) declined 93%. This may not sound like a big difference because they both did terribly, but an 84.3% loss requires 640% growth to get back to break-even whereas a 93% loss requires 1,430% growth to get back to break-even. Put differently, that's a 9.7% annualized return for 20 years for the growth stocks versus a 14.2% return for 20 years for value stocks! When the flood comes, you don't want to be in deep value stocks.
Does this mean that value-investing isn't the way to go? Not at all. It just means that buying something simply because it is statistically cheap doesn't mean it will do well in all situations. Just because it has done well doesn't mean that it will continue to do well. Unless 100 year floods are a thing of the past or you can predict them with great accuarcy, you probably want to make sure your portfolio isn't filled with deep value stocks.
When evaluating investment managers, this method of investing issue becomes critically important. Looking at someone's 10 or even 20 year record isn't enough. You have to know more about the process they use. If Investor A has earned 18% returns by investing in deep value stocks, and Investor B has earned 15% returns by buying good companies below fair value, you may actually want to go with Investor B. That is, unless you know how to predict 100 year floods...
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