Which Is The Better Investment?

Let's say you inherited $100,000 from a relative and you were committed to investing that money for you and your family.  To make this even more hypothetical, let's say that someone approaches you with two investments described below:

  1. A growing technology company that has been expanding at a rapid pace.  They have grown their revenue at 30% per year for the past five years and look poised for continued growth.  They have seen significant stock price appreciation as the outlook seems very bright.
  2. An industrial supply company that has basically been stagnant for the past 10 years.  While they aren't losing money, the economy has been tough on them as more manufacturing is being famed out of the country.  Their stock has languished losing about 20% of its value over the past five years.

Which would you rather buy?  If you read this blog at all you're probably sensing a trick question.  You're right.  But before we get to the answer, let's go back to the companies described above.  I have defined textbook growth and value companies.  Growth companies tend to be expensive (high price compared to earnings) because they are growing so quickly.  Great examples today would be Amazon or Netflix.  The second company is a value company.  Their stocks are cheaper because their future prospects look dim.  Some examples today would be financial stocks and energy producers.

Most of us are drawn to the growth companies.  They have great stories and seemingly only know success.  Value stocks are boring and often have seen their stock prices get beat up.  But we have data that we can point towards to tell us which have been the better investment.  Below is a chart of rolling five year periods comparing growth stocks to value stocks.

value v growth (1)

As you can see, value stocks are the clear winner (when returns are above 0% value outperforms, below 0% growth outperforms).

  • Value stocks outperform growth stocks an average of 4.8% per year since 1926 (rolling 5 year periods)
  • Value stocks outperform growth stocks 83% of all rolling 5 year periods since 1926

So why should that be?  As an investor, the growth company seems like the safe one.  It would be hard to argue that Amazon is going to be out of business in 10 years.  But what about a small oil driller in the mid-west?  There is a tremendous amount of risk investing in a stock like this.  And there is your answer.  Value stocks are riskier than growth stocks.  In order for them to attract capital, they must offer higher rates of return to their investors.  More risk, but expected returns are higher as well.

We are in a period today where not only has the value "premium" over growth been trailing its average, but it has been negative!  As you can see from the chart it is fairly uncommon for value stocks to trail growth stocks for a five year period.  We believe this presents great opportunity for investors over the coming years ahead.  One last piece of information- while the example at the beginning of the article was used to make a point, we don't believe anyone should try to pick one (or a few stocks) to capture the value premium.  This is best done by buying ALL of the value stocks, which is reflected in the chart.  No matter what you invest in, putting all your eggs in one basket is never a good idea.

Data source:  Fama French HmL Research Index.  DFA Returns Program 2.0

Innovation Has No Bounds

Sometimes clients question whether the market can keep going up from here.  The S&P 500 hit an all-time high yesterday and I get more questions from clients on whether this can continue versus how high it can go.  This skepticism is not unfounded.  In the past 15 years we’ve experienced two bear markets that erased 50% of stock portfolios so you can understand why investors might be a little bit skittish.  But there is an important point in all of this that we all must realize:  markets work.  Companies take raw materials, labor and ideas and turn them into something that is greater than the sum of their parts.  This has been evident throughout time and ingenuity doesn’t just stop because people are worried about stock valuations, employment or the direction of our economy.

Case in point, many of you may have heard that Google is working on a self-driving car.  Here is a link to more info on this innovation.  Think about the possibilities if something like this takes off.  Cars being able to go 100 mph without risk of accident.  Being able to sleep or work during travel will make everyone more productive.  This just scratches the surface of what innovation will be able to accomplish in fields like medicine, energy and computing.  For those who are uncertain about the future, I would encourage you to realize that uncertainty is normal, but so is innovation.  This ingenuity will allow companies to create new products and greater profits in the years and decades to come.

You Are Not A Contrarian

It seems like every investor (amateur or professional) bills themselves as a contrarian.  They will tell you that they tend to buy companies that are unloved or unwanted when they are trading for a great bargain.  The simple fact is that this is very hard.  The Motley Fool has a great article on this very topic.  Here is a key excerpt:  

One of the biggest ironies in investing is that while almost everyone thinks they are a contrarian, almost no one actually is. I remember 2007, right before the market peaked. Just about everybody I knew thought they were a value investor, zigging where others zagged. But at investing conferences, you found out that all these guys were basically buying the same stocks. What people thought was a contrarian view was actually rampant groupthink. It felt great when you, the “contrarian,” had your views confirmed by another “contrarian.” But contrarianism isn’t supposed to feel good, and you’re not supposed to have it confirmed by others. That’s why so few can actually do it. It’s rare — not impossible, but rare — that someone can remain blissfully content when everyone else around them thinks they’re crazy. One of the nastiest tricks our minds play is convincing nearly all of us that we can be that person.

I highlighted the most important part.  Being a contrarian goes against almost every fiber of of who we are.  The data from the research shows that most investors are the opposite of contrarians…they follow the herd.  In my opinion there are a few ways you can fight this urge:

  1. Rebalance without thinking too much- if you have targets for your portfolio you should periodically be rebalancing to bring things back in alignment.  Don’t overthink this…just do it.  It will be hard.  Right now you would be selling US stocks and buying bonds and emerging market stocks.  They are completely unloved, but I thought you wanted to be a contrarian?  
  2. Automate things- if there is a way to automate this process, even better.  Then your mind can’t get in the way.  Things like bi-weekly contributions to a 401k into a group of funds (some of which will most likely be things you don’t like to invest in) or auto rebalancing a portfolio is a great way to do this.
  3. Be diversified- one thing that can go wrong if you are a contrarian is a bankruptcy if you are buying an individual security (higher risk when you are buying companies that are in distress).  Keep your investments broadly diversified and avoid buying individual stocks.  It makes it a whole lot easier to be a contrarian when you know the permanent loss of your money is off the table.

The Stock Market Does Not Equal The Economy

The economic data coming out these last few weeks have been spectacular.  Whether it be employment, manufacturing or consumer spending, the economy really seems to be on a roll.  Before you go out and buy some stocks as an early Christmas present, it is important to remember that the economy is not the stock market.  We’ve talked about this before and we’ve posted a great chart from The Business Insider (originally Vanguard data) that shows this to be the case:

stocks economy cotd

 

You’ll see that there is no real correlation between a country’s stock market return and GDP growth.  Why is that?  First of all, the market as a whole is pretty smart.  Most situations where a country’s economy is going to slow down or expand is known well advance by market participants and is already priced into the market.  Second, just because a country is doing well economically, it may not mean that the companies that are domiciled in that country are experiencing the same growth.  If they are multinational companies they may be experiencing growth or contraction in other areas of the world.  

Just look at Thailand and Turkey on this chart.  Over the past 42 years they have experienced almost identical GDP growth, but Turkey’s stock market has grown at 12% per year while Thailand is growing at less than 1%.  Please remember this chart when you hear a pundit talking about how the market is going to perform because of some prediction he is making on the economy.  They aren’t correlated directly and it is dangerous to make investment decisions on such factors.

The Predictive Power (Or Lack Thereof) Of Stock Market Indicators

There is really no indicator that we know of that can predict stock market performance.  If there ever was it would very quickly be arbitraged away since markets tend to be fairly efficient.  Merrill Lynch uses a metric they call the “Sell Side Indicator” to determine future stock performance.  The indicator attempts to measure Wall Street analyst’s optimism or pessimism towards stocks.  The theory goes that the more pessimistic analysts are about stocks, the better the time to invest.  Here is the chart:

sent 2

 

You can see, that while the indicator has come back recently, it is still at the lows of 2008 and is considered to be extremely bullish for stocks.  Of more interest to me is their backtesting on this metric.  As you’ll see it has better predictive power than many other common metrics:

sent 1

 

With that being said, it still only has an R squared of .28.  To give you an idea of what that means, if it had perfect predictive power it would have an R squared of 1, so it is far from being accurate.  One of the best takeaways from this report is that there is no metric you can use to predict stock market performance with any degree of certainty.

Information contained herein has been obtained from sources considered reliable, but its accuracy and completeness are not guaranteed. It is not intended as the primary basis for financial planning or investment decisions and should not be construed as advice meeting the particular investment needs of any investor. This material has been prepared for information purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Past performance is no guarantee of future results.