Two Nobel Prize Winners, Warren Buffet, and Your Portfolio
“I'd compare stock pickers to astrologers but I don't want to badmouth astrologers."
― Eugene Fama (2013 Nobel Prize in Economics)
“It's like a crapshoot in Las Vegas, except in Las Vegas the odds are with the house. As for the market, the odds are with you, because on average over the long run, the market has paid off."
― Harry Markowitz (1990 Nobel Prize in Economics)
Passive investing through index funds has taken the world by storm in the last decade, but what portions of the stock market should we invest in, and why? Maybe it comes as no surprise that certain parts of the stock market, or asset classes, outperform others. In 2013 economist Eugene Fama won a Nobel Prize for his research with Kenneth French for their creation of what became known as the Three Factor Model. Their research determined that over time stocks have outperformed bonds, small company stock has outperformed large, and value companies have outperformed growth. When evaluating our investment portfolios, being conversant in the ideas they set forth allows us to make a deeper assessment of where we stand and how we might use their research to shape our asset allocation to profit.
Let's start by exploring the various characteristics of each asset class, and then follow that with a discussion of how their Nobel award-winning research can be used to allow us to harness market returns in our portfolios.
Large Vs. Small
While you can purchase just under 20,000 United States company stocks on any given day, the majority of trading volume involves just the 500 largest public companies, represented by the S&P 500. It also so happens that the large majority of stocks owned by the public involve this roughly 2.5% of available companies.
But while at first it might seem surprising that this top echelon takes up most of the trading, the reality is that the size of these companies also comprises the large majority of the total value of available stock. In fact these 500 companies make up about 80% of total market value.*
A large capitalization stock is generally designated as one with a total company value (determined by multiplying the stock's price by the number of shares issued) of $10 billion or more. Companies valued at less than $10 billion are considered mid-cap or small cap. Vanguard's top five holdings in its S&P 500 index fund include: Apple, Alphabet, Microsoft, Exxon, and Johnson and Johnson. You've heard of them.
While the S&P 500 often serves as a rough shorthand for large-cap stock a common index used to track small cap stocks is the Russell 2000, which measures the bottom two thirds of the 3,000 largest traded companies in the US. It's likely that unless you work for one, you have never heard of most of the small caps. Have you heard of Vanguard's top five holdings for the fund that tracks the Russell 2000 which include: Advanced Micro Devices Inc., Microsemi Corp., Gramercy Property Trust, Healthcare Realty Trust, and IDACORP Inc.?
In technical terms, value stocks are those that have high book-to-market ratios. In English, this means the actual worth of all their assets and debts compared to their market price is higher than similar companies in their industry.
Value investing was pioneered by Benjamin Graham, and brought to the mainstream conversation by his most famous acolyte Warren Buffet. Graham and Buffet basically argue that the quality of a company is measured by its underlying balance sheet, business assets, and competitive advantage in the marketplace.
The goal of value investing is to participate in the profits of a well run business which by book to market valuation is underpriced. As Buffet has often been quoted, “It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” Value investors like Buffet are constantly looking for stocks that have fallen out of favor for one reason or another with other investors but whose underlying success is established and will continue. The expectation for a value stock is that it will provide stable long-term growth as the underlying company continues to succeed and its price in the long term tracks this success.
An alternative to Buffet's method of investing directly in individual value companies is to buy shares of a fund, or possibly an index fund that owns stock in hundreds, or thousands, of value companies.
Dividends & Value
One of the chief attractions of value stocks in today's economy is that these mature companies often distribute a quarterly dividend. Many established companies have been distributing a dividend for several decades. While Chevron's stock has fluctuated heavily with the fall in oil prices, Chevron itself continues to maintain a deep commitment to maintaining its dividend. In the last few years it has actually been taking on debt to keep its dividend stream steady as the profitability of its oil business has suffered. Regardless of the price of the stock this quarter, Chevron committed to pay out $1.07 per share as a dividend. On an annualized basis this currently is about a 4% return on a share of Chevron's stock which hovers around $100.
While companies with value stock often have a track record of long term success, the appeal of growth stocks is their future potential. Growth companies, like Elon Musk's Tesla, or Marc Benioff's Salesforce are valued for their future balance sheets. When people purchased shares of the Netflix IPO in 2002 at $15/share it wasn't because of its dividend or its healthy war chest of capital. It was valued for its expected growth. Now, with the stock hovering around $100, not a soul expects a dividend next quarter. Growth companies put their revenue back into the company. No one is surprised when Netflix decides to make another season of House of Cards instead of paying out a few cents a share to investors in a dividend. No one is surprised when Elon Musk announces the Model 3 is in the making instead of relaying that he's paying a dividend.
While Warren Buffet has lived out success in value investing, Musk is doing so in his vision for building great growth companies. Musk once said, "My proceeds from Paypal were $180M, I put $100M in SpaceX, $70M in Tesla, and $10M in Solar City. I had to borrow for rent." Not even the founder of these growth companies is interested in their present profitability. It's about the future.
We admire the time tested strategic acumen of Warren Buffet and the visionary courage of Elon Musk, but where does this leave our portfolios?
What the Research Has Shown Us
The Swedes dished out a Nobel prize to Fama because they explained how fund managers had been beating the overall market. Portfolios that over time were consistently tilted towards small and value stocks consistently beat funds that merely tracked the S&P 500. The managers' success didn't necessarily mean that they were great stock pickers, but rather that they had weighted their funds to take advantage of an overall factor that held true across the market.
So how have large and small cap stocks done? Well, from 1926 to 2013 small caps returned an annualized 11.88%, while large caps returned 9.84% in the same period.*
But 1926 was a long time ago. How about our lifetimes? In the 26 year period from 1990 to 2015 Large Cap Growth increased at an annualized rate of 8.60% while Large Cap Value returned 9.03%. Small cap returned 9.26%. Even more overwhelming was Small Cap Value which returned 10.19%.*
While at a glance these annualized differences might appear inconsequential, the actual results are significant. $10,000 invested in Large Cap Growth in 1990 would now be worth $85,435, while that same amount invested in Small Cap Value would be worth a whopping $124,669. That's an extra 68%! Now, what if we invested $100,000 instead of $10,000? Or add another zero. That's not chump change.
I'm a proponent of index funds. Choosing and re-balancing your indexes is clearly an important aspect that is often misunderstood by individual investors. Clearly investing in the S&P 500 over the last 50 years would have been a very good idea. But by tilting your portfolio towards value and small stocks over the long haul, you would have significantly outperformed the market as a whole.
A discussion of price volatility, standard deviation, and beta are outside the scope of this writing. Suffice it to say, various asset classes will perform differently in different markets. Beta measures how much a stock or an asset class deviates from the market as a whole. Standard deviation measures the up and down swings of an asset class. Emerging market small growth stocks can take you on wild, wild ride. They will have a high beta as well as high volatility. Treasury bonds work in the opposite way. They aren't going to give you a major swing and will provide consistency for you in times of turbulence.
Interestingly, from 1990 to 2015 value not only beat growth, but it also exhibited significantly less standard deviation (16.67 as opposed to 21.42), which is one of the primary ways investors measure volatility, and thus risk.
The work of another Nobel prize winner, Harry Markowitz, is worth mention here. Markowitz's Efficient Market Hypothesis showed that by adding various asset classes (diversification), you can increase return while simultaneously taking less risk. The inclusion of various asset classes in a portfolio increases stability because they do not run in lockstep with each other. By thoughtfully blending large cap, small cap, international, value and growth stock with appropriate bond portfolio you can take advantage of Markowitz's EMH.
I cannot (nor would I want to) prescribe a portfolio for you here. Your asset allocation should reflect your long and short term values and vision, your appetite and need for risk (which I wrote about here), and your career position and trajectory. You should work with a knowledgeable and caring planner for that.
But what I can say is that understanding the potential upsides of tilting portfolios towards value and small stock as asset classes, should be part of your conversation. This is especially true for investors that have a long timeline for their investments. Brokerage firms such as Schwab, Vanguard, and TD Ameritrade have funds which you can include to add a value/small tilt in your portfolio. They may vary slightly in their holdings, but by and large are they are going to perform very similarly. If you're interested in looking under the hood of some funds you might start with Vanguard's VIVAX for Large Cap Value, NAESX for Small Cap, and VISVX for Small Cap Value.
Another alternative is to invest in funds that themselves tilt their portfolios towards small and value stock. This is exactly the premise behind mutual fund company Dimensional Fund Advisors. In conjunction with Fama, one of his former students began Dimensional to take advantage of (among other things) the small/value premiums. Even their large cap growth funds contain an element of small cap stock and tilt toward value companies. This has allowed them, over the course of time, to outperform other similar funds. To keep fund trading relatively stable and, subsequently, costs down, Dimensional funds are made available primarily to institutions and through their network of approved investment advisors. Baron's did a great article on Dimensional a few years back. You can read it here.
A Challenge From the Recent Past
It's interesting to note that over the last few years growth companies have outperformed value companies. This should come as no surprise. There are going to be seasons, sometimes prolonged ones, when value funds lag growth. As the economy rebounded after 2008 growth companies picked up the pace faster than value. Some economists have gone so far as to say that this means the era of small and value stocks beating the market is over. And, while they can make an articulate case, history points against them. Only the future will tell for certain, but I like to think of these short term results as an opportunity to buy value and small stocks on sale.
Where We Sit in the Picture
Maybe we should consider, on a basic level, why value and small company indexes have lead the market for the last 90 years.
Why would this be? It passes the common sense test for me. Small companies have the agility to grow, and most large companies started as small companies. While some companies just IPO as a top 100 company (Facebook opened at a valuation of $104 billion), many get there over the course of several years. Why not take advantage of the small company growth, rather than wait to include them in your portfolio until they have grown large?
What about value beating out the growth indexes? I think growth is especially attractive to us living in the Bay Area. Most of us identify more with Musk or Zuckerberg than with Warren Buffet. It's our generation. And my friends aren’t working at a startup because they are risk averse. But those who have been around for a while have experienced the statistics first hand. Nine out of ten startups fail. What about the growth companies that get valued for their future growth, and then never meet expectations? Is Tesla going to justify its price tag? I hope so. But for every successful Tesla there’s a dozen who don’t make it. Value stock may not be sexy, but GE and Johnson & Johnson sure have stuck around to make money for a long, long, time.
I think the case for us in the Bay Area to invest in value companies is especially strong. Our human capital and future earnings are in one way or another likely tied to the growth companies of the Bay Area. By tilting our investment portfolios towards value we can diversify so that not all our eggs are in one basket. This is where we take the research and apply it to our own lives. What do you think?