Oxstones Investment Club™by Brett Arends, Market Watch,
Commentary: The one thing investors need to know
Wall Street has a wide array of mutual funds it wants to sell you. “Absolute return” this. “Midcap blend” that. “Small-cap growth” whatever.
Many brokers, advisers and salesmen will tell you that just the right mix of each one will give you a portfolio that’s “right for you,” with returns perfectly adjusted to your “risk tolerance.”
Phooey.
Before you invest a penny, listen to Bob Haugen.
He’s a former finance professor who’s spent half a lifetime studying the stock market. He’s written a number of books and papers, and is the co-author of remarkable piece of analysis entitled “Case Closed.”
He looked in excruciating detail at the characteristics of which stocks did best (and worst) over nearly half a century, from 1963 to 2007.
His finding?
Most of these “styles” are a waste of time. And the idea that you need to take on more “risk” to earn higher returns is a total con.
On the contrary, he says, the stock market has a big secret.
Over many decades, “the stocks with the highest risk produced the lowest returns — and stocks with the lowest risk produced the highest returns.” In other words, he says, “the risk/return ratio was upside down … the payoff to risk is consistently negative over the 45-year period of this study.”
Instead of being paid to take risk, you got paid not to.
All those glamorous, sexy ÃÂgrowth’ stocks? All that extra volatility you took on in the desperate pursuit of the next big thing? It was a bad move.
You would have done much better investing in the dull, low-risk, widow and orphan “value” stocks.
These winners were stocks that were cheap in relation to their net assets, earnings, cashflows, and dividends. They were stocks in companies that had big and growing profits today, not pie-in-the-sky expectations for next decade. They often also had recent positive momentum on the stock market.
While Haugen tells me it’s rare to find an individual stock that’s a “perfect fit,” you can build a portfolio of stocks that are good fits.
Investing in value works. Haugen and Nardin Baker, in “Case Closed,” wrote: “the evidence strongly suggests that this simple intuition is more powerful than any of the complex theories about expected return that can be found in the literature of Modern Finance!”
They actually earned you more money and gave you a smoother ride. The strategy worked even after counting trading costs.
This has not just been true in the U.S., either. Haugen has also looked at historical data on the British stock market. On the Paris bourse. In Germany. In Japan.
The results were the same. Lower volatility stocks gave you higher returns. A free lunch.
Many professional investors already know this. But too many don’t. And many of those who do know it keep forgetting it &mdash and rushing out and chasing expensive “growth” stocks all over again. That’s what’s been happening lately (more on this below).
Wall Street doesn’t spread the value message too widely to the public, either. It’s hard to explain to customers. And if the customers knew there was a simple way to get more return with less risk, why would they need their fund managers?
Haugen is not alone in his analysis. For years, contrarian investors have highlighted data showing that “value” has beaten “growth” over any decent stretch of time.
James Montier, the renowned strategist at GMO, once showed that the great Japanese bear market over the past 20 years has been due entirely to falling “glamor” stocks. If you had owned Japanese value stocks, and “shorted” or got against the glamor stocks, he found, you actually would have made money.
This free lunch proves that the market is far from perfectly “efficient.” Haugen himself argues it drives “a stake through the heart of the efficient market hypothesis.”
Even members of the efficient market cult have been forced to concede some of these points. For decades they maintained that to earn higher returns, you needed to take on more volatility, or “risk.” Then they looked again at the data and realized it wasn’t quite true. They admitted, instead, that small companies had done better than large companies. And value stocks had done better than growth stocks — even though they entailed less risk.
Oops. So much for efficiency!
What does this mean for you today?
It just so happens that growth stocks have boomed in the rally of the past two years. Once again, investors have allowed themselves to start dreaming of future glory instead of looking hard at present day profits. Since the start of 2009, growth stocks have outperformed value by 20%, according to FactSet. That’s an incredible margin. Small-cap growth stocks have done best. And large-cap value stocks &mdash the safest of them all &mdash have done worst.
If history is any guide, this will be a temporary phenomenon &mdash and an opportunity for wise long-term investors. The obvious conclusion is that this is a moment to dump growth stocks and buy value stocks, or value funds, instead. While I am cautious about the stock market overall at current levels, if I were buying stocks here I’d buy a low-cost, large-cap value fund.
Brett Arends is a senior columnist for MarketWatch and a personal-finance columnist for the Wall Street Journal.
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