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Stingy Investor Tip Sheet

Value's Downside Risk

I stumbled across an OID interview with Richard Pzena and his graph "Declines of 20% or more in a value strategy 1968 - 2007" (on page 2 of the linked PDF) stuck with me.

Here's a bit of what he said...

"if you had invested in a very simple strategy of buying low price-to-book stocks over the last 40 years [based on the cheapest quintile of the largest 1000 stocks], you'd have made about 200 times your money versus about 60 times your money if you'd invested in the S&P 500. So it's a pretty successful strategy.


Now, what I want to focus on are the eight times in the last 40 years that you would have lost 20% in a naive value strategy. When you look at chart 1, those circles are little blips in the scheme of going up 200-fold. And from a purely analytical perspective, you'd just look at it and say, 'Who cares if I'm down 20% eight times? I'm up 200-fold over this 40-year period.' And I think that's actually quite a logical conclusion. The problem with that conclusion, though, is that while you're losing that 20%, it doesn't feel very good. And not only doesn't it feel good, you start to question whether you're doing the right thing. And when you have clients who are entrusting you with their money, they for sure will question if you know what you're talking about. They'll say, 'Wasn't it obvious that whatever was going to happen was going to happen? Everybody in the world seems to know it except you.'


So given that, what do you do? Well, my solution - because I haven't yet figured out how to avoid those -20% periods in my career - is to promise them to my clients. I tell them, 'This is going to happen. And if you don't like it, we're not the right people for you.'"

Pzena's speech is quite clever in two ways. First he took a hard look at value investing's down periods. Second, he also highlighted the track record to his clients to prepare them for the inevitable hard times.

I thought that it'd be interesting to create a similar graph using Kenneth French's data which is available from mid-1926 and through to the end of 2008.

I use French's data for three B/P value-weighted portfolios which are rebalanced each June. The 'low 30%' portfolio contains 30% of stocks with the lowest B/P ratios (or highest Price-to-Book-Value ratios). The 'med 40%' portfolio tracks the medium 40% of stocks based on B/P. The 'high 30%' portfolio tracks the 30% of stocks with the highest B/P ratios (or lowest P/B ratios). I call the low 30% portfolio the glamour portfolio and the high 30% portfolio the value portfolio. The small assortment of stocks with negative book values are not included.

Growth of B/P portfolios

The first graph simply displays the growth of a $1 investment in each portfolio (not including commissions/trading costs) since July 1926. Due to the significant gains, it's hard to see what happened in the early years.

Overall, the glamour group turned the $1 initial investment into $1,074. The medium B/P group climbed to $2,415. But the value (or high B/P) group vaulted to $14,508 over the entire period.

If you ignore the latest market downturn, the low B/P group peaked at $1,816, the medium group at $4,877, and the high B/P group topped out at $30,289.

(click for larger version)

To better see the ups and downs of the entire period, the next graph uses a log scale on the portfolio-value axis.

(click for larger version)

You'll note that the 1930s period was very hard on value stocks which is a little unsettling for value investors.

Declines From Prior Peak

The next five graphs highlight the downside risk of the various B/P portfolios more dramatically. They plot each portfolio's decline from its prior peak.

The first graph highlights all three portfolios. But it can be hard to follow them all at once. That's why I show each group's experience in the following three graphs. Finally, I provide a graph with only the value and glamour groups in an effort to better highlight the periods when one outperformed the other.

(click for larger version)

(click for larger version)

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(click for larger version)

(click for larger version)

As is plainly demonstrated, the value group (high B/P) has suffered numerous down periods. However, apart from the 1930s, these periods have tended to be shorter and less extreme than the downside experience of the glamour (low B/P) group.

Regrettably, the last few months have been harder on value stocks than on glamour stocks. But go back a little further and the value group climbed nicely in the early 2000s whereas the glamour group is still below its summer 2000 peak. Indeed, value stocks are a bit above their summer 2000 levels whereas glamour stocks are down about 40% over the same period.

05/27/2009   7:30 PM EST   Permlink   save & shareP/B

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