Factor Based Investing: Long-Term Performance vs Short-Term Disappointment

If you’ve had a globally diversified portfolio, you know:

You’ve already have your low-cost, globally diversified portfolio to help you achieve your personal goals. You’ve done so by tilting your portfolio toward or away from long-term sources of expected returns – and their risks. When those risks arise, if your goals haven’t changed, neither should your portfolio.

Let’s assume you’ve already embraced this advice, and are relatively comfortable maintaining your investment resolve. You also may be aware that investments concentrated in value stocks have delivered higher long-term returns than their growth stock counterparts. As Multifactor World’s Jared Kizer describes in a January 2019 post, “value stocks have outperformed growth stocks by 4.8 percent per year over the period of 1927–2017.”

But it’s also no secret that the value premium has been hiding for quite a while. At least in U.S. markets, value stocks have been under-performing relative to growth stocks for around a decade. This has led some investors to wonder whether the value premium has lost its mojo.

Nobody knows for sure what the future holds; we cannot guarantee success. But based on historical and ongoing evidence, we have found no compelling reason to alter our approach to value investing. 

Historical Context

In 1992, professors Eugene Fama and Ken French published a landmark study in The Journal of Finance, “The Cross-Section of Expected Stock Returns.” Their work gave birth to the Fama/French three-factor model, which suggested three sources of expected returns could explain almost all of the differences in returns among different portfolio builds:

  • The equity premium – Stocks (equities) have returned more than bonds (fixed income).
  • The small-cap premium – Small-company stocks have returned more than large-company stocks (although continued inquiry has added an important footnote to this finding).
  • The value premium – Value stocks have returned more than growth stocks. Value companies are those that appear to be under- or more fairly valued by the market, relative to growth companies; they exhibit lower ratios between their stock price vs. business metrics such as book value, earnings, and cash flow.

What does this mean to you as an investor? It suggests financial analysts can take any two investment portfolios and compare their long-term performance using just these three factors. With more than 90% accuracy, the analysis should explain why one portfolio returned, say, 10% annualized over 20 years, while the other one only returned 5%.

To put it another way, the Fama/French three-factor model showed us that, costs aside, it barely matters whether each security in your portfolio has been hand-picked by a high-priced expert, or chosen at random by a group of dart-throwing monkeys. Almost all that matters is how you’ve allocated your holdings among (1) stocks vs. bonds, (2) small-cap vs. large-cap stocks, and (3) value vs. growth stocks. Almost any other stock-picking or market-timing efforts are far more likely to add unnecessary costs and/or unwarranted risks than to improve your returns.

This is powerful stuff to build on. In 2014, Fama and French published a five-factor asset pricing model, which now explains nearly 100% of the cross-section of expected returns. Whether returns among different portfolio builds can be explained by three or a few more factors …

If your investment portfolio were a house, your particular allocation to value stocks is an essential, load-bearing wall. It should not be abandoned lightly.

The Investor’s Long Haul

Still, we understand. A decade is a long time to tolerate disappointing numbers, while awaiting an expected reward. However, as is the case for any other source of expected investment returns (including the equity premium itself), we prefer to consider value stock performance over a decade or more, since the expected out performance can go into hiding for years on end – and often has.

In a 2015 CFA Institute post, Enterprising Investor contributor Dougal Williams commented (emphasis ours): “A ‘disappearing’ value premium, even over a 10-year stretch, is nothing new. In fact, since the late 1970s, 27% of all rolling 10-year periods have seen a negative value premium.” Of course, on the flip side, this means 73% of them delivered a positive premium.

Only those who can tolerate the doldrums tend to still be around to reap the unpredictably timed windfalls that often dramatically impact your end returns. As Vitaliy Katsenelson of Contrarian Edge has suggested more recently, “value investing is not dead; it is just waiting until all value managers lose their hair and capitulate.”