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Why We Do What We Do Redux

Why We Do What We Do Redux

January 24, 2023

The underlying philosophy and principles of our portfolio construction is based upon significant historical and independent academic research. This is not guesswork, but simply acting on what the long-term, empirical data tells us. The premiums mentioned and discussed below do not show up every year nor even sometimes for an extended period of time. However, as the evidence illustrates, for long-term oriented investors, they eventually emerge and enable premium returns toward portfolios with a tilt toward stocks, small and value companies. How much of a tilt depends upon an investor's discipline and ability to tolerate under-performance in some or even multiple years.

The first foundational building block being Nobel Laureate  Eugene Fama's "Efficient Market Hypothesis," which is the basis for much of today's index investing. The second is Nobel Laureate Harry Markowitz' "Modern Portfolio Theory" which teaches us that non-correlated asset classes (meaning they do not move the same way at the same time) combined in a portfolio will generally lead to long-term higher expected rates of return and less volatility. The third is the Fama-French "Three Factor (now five factors) Model" which illustrates how premium returns can be derived from specific market factors such as equities over bonds (or fixed income), size (small companies outperform large ones) and value (distressed or lower price stocks relative to asset value) outperform growth stocks. There are a couple of other factors but they are not the topic of this piece.

The latter, "value," seems counter-intuitive until one fully comprehends just why there are "returns" in the investment market. In order to attract capital to businesses a return has to be offered in return for assuming the risk of investing. In the case of value stocks, since they have more risk than rapidly growing companies they have to offer more potential return in order to attract investors' capital. Logic dictates that if one could receive the same compensation for investing in growth stocks as value ones, why would anyone ever invest in a value stock? Thus, over the long term, higher "expected" rates of return.

So what does the study of investment history teach us and specifically related to asset classes? The below brief explanation, provided by Dimensional Fund Advisors (whose funds provide the core of our equity investment portfolios) supplies the historical evidence behind value stocks' long-term premium returns. 

"There is pervasive historical evidence of value stocks outperforming growth stocks. Data covering nearly a century in the US, and nearly five decades of market data outside the US, support the notion that value stocks—those with lower relative prices—have higher expected returns.

Recently, growth stocks have enjoyed a run of outperformance vs. their value counterparts. But while disappointing periods emerge from time to time, the principle that lower relative prices lead to higher expected returns remains the same. On average, value stocks have outperformed growth stocks by 4.1% annually in the US since 1927, as Exhibit 1 shows.



Value Add from 1927 through year end 2021 is an outperformance of 4.1% per year over growth stocks.

Yearly observations of premiums: value minus growth in US markets, 1927–2021 (Dimensional Fund Advisors)

Past performance is no guarantee of future results. Investing risks include loss of principal and fluctuating value. There is no guarantee an investment strategy will be successful. The Fama/French Indices represent academic concepts that may be used in portfolio construction and are not available for direct investment or for use as a benchmark.  Index returns are not representative of actual portfolios and do not reflect costs and fees associated with an actual investment. 

Some historical context is helpful in providing perspective for growth stocks’ recent outperformance. As Exhibit 1 demonstrates, realized premiums are highly volatile. While periods of underperformance are disappointing, they are also within the range of possible outcomes.

We believe investors are best served by making decisions based on sound economic principles supported by a preponderance of evidence. Value investing is based on the premise that paying less for a set of future cash flows is associated with a higher expected return. That’s one of the most fundamental tenets of investing. Combined with the long series of empirical data on the value premium, our research shows that value investing continues to be a reliable way for investors to increase expected returns going forward."