David Booth on Value and Values
Transcript
We built Dimensional around sensible ideas which are compelling, implementable, and well-documented by decades of investment research. When forming portfolios, we start by deciding how much to hold in relatively risky assets, such as stocks, and how much in relatively riskless assets, such as bonds and bills.
The stock-market premium, which is the expected premium return of stocks over Treasury bills, makes sense to us because stocks are riskier than Treasury bills. Bonds are backed by a promise to the investor, while stocks offer more uncertainty. Because the investor takes more risk investing in stocks than bonds, they expect to be paid a higher return.
I haven’t met many people who expect stocks returns to be less than T-bills. But back when we started the firm, we found ourselves at the end of a 16-year period where T-bills had outperformed the stock market. The cover of BusinessWeek proclaimed, “The Death of Equities.” People were saying the stock market would never be positive again. Then came the best 19-year bull market run in history.
In addition to the stock premium, we think it’s reasonable to expect that holding small cap and value stocks in a greater proportion than they make up in the market will increase a portfolio’s expected return. Not only does the research show this to be the case, but the value and size premiums make intuitive sense. Low-priced stocks, like value stocks or small cap stocks, should have higher expected returns. In both cases, they sell at lower prices relative to growth and large cap stocks. All other things being equal, the lower the price you pay for an asset, the higher your eventual return. As my friend and colleague Robert Novy-Marx has said, “I wake up every day expecting to see a positive value premium.”
But obviously, that is not what always happens. All three of these premiums are not always positive. If they were, they would violate the notion of risk and return. So we’ve always understood and explained to our clients that there will be periods when one group outperforms another. That’s what we’re seeing right now with value.
It’s uncomfortable, but it’s not surprising. And it’s also not that unusual. Fama and French estimate that over a 10-year period, there’s a 15% chance the stock market will underperform Treasury bills, a 17 % chance value will underperform growth, and a 28% chance small caps will underperform large caps. This is basic statistics, as true now as it was when started our firm almost 40 years ago, and has to do with the size of the various premiums relative to their variability.
So there can be long periods of time when any of these premiums, stock market, value, and size, can go in either direction. And even during a long period, such as now without a positive premium, there’s no compelling research that says size and value expected premiums should no longer be there, just as there was no compelling research that says the stock market premium should no longer be there, even at the end of that disappointing 16-year period.
We’re often asked, how long do I have to wait to see positive premiums return? There’s no obvious answer. But if you have a sensible, implementable idea, well-documented by academic research, why would you ever give up on it?
We focus on controlling what we can control, which is how we implement these strategies. We fight for every basis point.
If you’re concerned about the performance of value stocks right now, maybe you own more than you’re comfortable with. That’s fair. But I’ve been doing this for 50 years, and again and again I see that returns come in spurts. That’s why getting in and out of the market repeatedly is a bad idea. You frequently are going to get caught on the wrong side of your decision. Returns cannot be timed nor predicted, which is why long-term investors have to be patient if they want the chance to capture premium returns.
It’s natural to question any strategy when returns are disappointing. We are a research-driven firm and for us to change our strategy we would need a brand-new theory, backed up by compelling evidence. Scientific rigor and the conviction that comes with it form the foundation of our core values, and that will never change.
GLOSSARY
Premium: Return difference between two groups of stocks.
Value stock: A stock trading at a low price relative to a measure of fundamental value such as book equity.
Value Premium: The return difference between stocks with low relative prices (value) and stocks with high relative prices (growth).
Profitability is defined as operating income before depreciation and amortization minus interest expense divided by book equity.
Disclosures
Eugene Fama and Ken French are members of the Board of Directors of the general partner of, and provide consulting services to Dimensional Fund Advisors LP. Robert Novy-Marx provides consulting services to Dimensional Fund Advisors LP.
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