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Capturing the wealth premium
By Bob Tattersall
TORONTO (GlobeinvestorGOLD) - I have been a value investor for over 35 years and believe that this is the only sensible way to manage a portfolio over the long term. So, you can imagine that I was intrigued by a research paper titled “Do Investors Capture the Value Premium?” by Todd Houge at the University of Iowa and Tim Loughran at the University of Notre Dame. With research papers, it is always a good idea to start with the conclusion to see if you want to wade through the equations in the body of the text. I have to admit that the final sentence was quite discouraging; “… investors should harbour no illusion that pursuit of a value style will generate superior long term performance.” No one likes to feel that his entire career has been constructed on an illusion, so I felt compelled to read the article in its entirety.
The research universe covered by this study is confined to U.S. data bases: individual stock returns, index profiles and mutual fund returns, and so the conclusions are not necessarily applicable to Canada. But the logic seems to apply to all developed markets, which suggests that the same trends are in place on the Toronto stock exchange even if the order of magnitude may be lower.
In the early 1990s, Fama and French observed that low price to book (value) stocks and small cap stocks delivered significantly higher rates of return than their large, more highly-valued counterparts. They didn’t find this particularly surprising since they believed that small size and value were associated with higher risk: investors in value stocks were simply being compensated for taking on greater risk. Houge and Loughran in their research paper attempt to establish whether or not investors can actually capture this abnormal return in the real world.
As a starting point, they look at the performance of the S&P 500 Index and the Russell 3000 Index after they have been sub-divided into value and growth components. Although there are periods when value outperforms growth and vice versa, over the entire period 1975-2002, value stocks outperform growth stocks by an insignificant 0.11 per cent per month. Since these two indices represent 78 per cent and 98 per cent of the market capitalization of all U.S. equities respectively, Houge and Loughran conclude that most investors will have difficulty capturing the value premium within the universe of securities of greatest relevance to them.
They then go on to examine the performance of growth and value-oriented mutual funds for the period 1965-2001. Although there is considerable variation in the year to year performance of the two styles, the long term results are virtually identical, although both styles of small cap funds did generate a substantially higher return than the large cap versions.
Finally, the researchers looked at individual stock returns over the period 1963-2001 and here they found that “small firms realize higher returns than large firms and value stocks (low P/B) earn higher returns than growth stocks”. So, Fama and French were in fact correct in identifying the presence of excess returns from small cap and value stocks: the problem seems to be in capturing this return at the index or portfolio level. Houge and Loughran tackle this issue by dividing the individual stock database into large cap stocks (the top 75% of market caps) and small caps (the bottom 25%) and re-running their analysis. They find that, in the large cap segment, size and value (price to book) have no statistically-significant impact on stock returns, but that small firms drive the value effect that has been reported in the literature. In their opinion, investors fail to capture even the benefit of small cap value stocks because of higher transaction costs and the higher management fees associated with many small cap mutual funds.
At this point, I think we have a classic “good news – bad news” story. The good news is that the research confirms the existence of superior returns from small cap and value investing at the individual stock level. The bad news is that the average mutual fund fails to bring this potential down to the bottom line for its investors. As a practical matter, how can investors (or the portfolio managers acting for them) increase the odds in their favour when operating in the value universe?
The implications from this research paper are fairly clear: if you hope to capture the value premium in the market, then you must be willing to own a large percentage of small cap names which are off the radar screen of the institutional investors. In addition, it is important to minimize trading costs, which implies low portfolio turnover and a measured pace when buying or selling positions and, finally, low fund expenses (MERs) if you are investing through a mutual fund. None of this will guarantee success, of course, but failure to follow these principles will almost certainly leave you chasing an illusion – not a great career trajectory!