Forever growth?

Growth stocks have been crushing value stocks over the last several years, by:

  • 6.3% year-to-date
  • 7.1% over the last year
  • 3.8% annually over the last 3 years
  • 5.5% per annum over the last 5 years

Such a strong run leads many investors to question if growth has formed a permanent advantage over value.  

Briefly, the answer is no.

Over the short to intermediate term, it’s quite normal for growth or value to out-perform for a time. But, these periods always end. Just looking back over the last 10 years, value beat growth by 1.1% annualized (even including the last 5 years of dramatic out-performance of growth over value). Over the last 80 years, the data are even more compelling: value has out-performed by over 3% a year.

What gives? Basically, investors tend to herd. They run in one direction for a while, take that too far, and then reverse direction. Value, after under-performing for 5 years, goes on to crush growth for the next 5 years. And then, following that, growth goes on to crush value for the next 5 years. Rinse and repeat. (It’s not always 5 years at a time–sometimes it’s 1.5 years, sometime 3, 5, 7, or even 10.)

Just like night follows day, growth and value go in and out of favor only to see that reversed time and again. Smart investors look to benefit from this regression to the mean by examining 20 years of results instead of the last 3 or 5 years. You can’t time the reversals, so don’t try.  Instead, bet on the long-run winning hand, and over time you’ll do very well.

You can well imagine that Apple’s outstanding growth and performance has greatly contributed to the excellent run of growth stocks over the last decade. Apple now accounts for 4% of U.S. Gross Domestic Product (GDP) and 4.4% of the value of the S&P 500.  

Even if Apple starts producing oil, cars, food, and all the other things in the economy (highly unlikely), its growth will eventually regress to the 3% growth of the underlying economy. When that happens, and it’s likely sooner than most think, Apple’s growth stock tailwind will turn into a headwind, and value will come back into favor.

I have no idea when this will happen, but I do know growth’s out-performance will end and value’s out-performance will re-emerge. In the meantime, I’ve positioned myself to benefit from long-run, time-tested investing wisdom instead of trying to play the short-run, unreliable trends of the moment. Over time, that is the winning hand.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Forever growth?

Extraordinarily average

Regression to the mean is a well documented phenomenon in investing, as it is in many other areas of life. 

It refers to the basic tendency of a statistical series to move toward average over time. Just as trees don’t grow to the sky and average IQ’s don’t double in a generation, returns on equity investments tend to move toward average, too.  

As I described in my January blog, this phenomenon can be used to profitable advantage, and now seems to be one of those times.  

Why do I think that? Because group performance of some stocks seem to be far out of line from long term history, and if those relationships are restored–as they always seem to be–then money can be made investing in a way that supports a regression to the mean.

To flesh this out, let me describe one way of looking at historic returns: by assessing them relative to company size and valuation. For example, you can group large companies together and small companies together, or look at companies with high price to earnings (growth) or low price to earnings (value).  

One popular way to look at this, used commercially by Morningstar and described academically in a famous study by Fama and French, is to break companies by size and valuation in to four groups: 1) small value, 2) small growth, 3) large value and 4) large growth.

I like to look at this data over 5 year periods to observe whether one group is moving further from average and may snap back.

Over the very long term, from 1927 to 2011, small value has been the best performing group, followed by large value, large growth and small growth. In fact, over 84 years of data, small value did 3.7% better than average, large value did 0.5% better than average, large growth did -1.7% worse than average, and small growth did -2.4% worse than average.  

If you’ve ever heard someone say buy small companies or value companies, they were referring to this long term data set.

But, there is a problem with just buying small value without further thought, because your particular returns depend on how far from average the data is at the time you purchase. If small value has done much better than average when you buy, it won’t generate historically average results for you. And, if small value usually does best but has been worst recently, you’ll probably do much better than historic average.

Knowing the long term average and recent performance can lead to profitable discoveries, in other words.

With this in mind, how has recent performance looked? Instead of small value leading the pack over the last 5 years, small growth has. The 84 year historic worst group–small growth–has been best over the last 5 years (+4.9% better than historic average). In my opinion, this seems like a terrible time to buy small growth.

Large growth, usually the second worst group, has been the second best group with 3% better returns than usual. Small value, usually the best group, has been the second worst, -2.5% worse than historic average. Large value, historically the second best group, has under-performed by -5.4%!

Does this mean something fundamental has changed, or will regression to the mean bring things back to average. Both analysis and experience leads me to believe that regression to the mean will occur like it always has, making small growth a poor place to invest and large growth the belle of the ball over the next 5 years.

Will this smooth transition begin the minute I publish this blog? Almost certainly not. And, that’s the rub: regression to the mean happens over the long term, not the short term. We don’t know when things will regress, only that they almost certainly will.

Will large value greatly out-perform small growth? I don’t know how soon or by how much, but I am very comfortable betting it will over time. As always, I’ve put my money where my mouth (blog?) is.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Extraordinarily average

Five year snap-back

Each quarter, Barron’s publishes how mutual funds performed by sector.  Sectors in this case refers to how mutual funds are categorized, like funds invested in large, mid-size or small companies, growth or value, bonds, international, gold, real estate, science and technology, etc.

I find this information interesting not because I think quarterly or annual performance is meaningful–it’s not.  You have to look at much longer periods, like five or ten years, to get meaningful information, and Barron’s publishes that as well.

And, here’s where things get interesting.  If a particular sector has done well over the last five years, does that mean it is likely to continue to do so going forward?  Not at all.  In fact, a good case can be made that the sectors that do best over the last five years are seldom if ever the one’s that do best over the following five years.

And, that’s what I look for in Barron’s tables.  I look for the sectors that have done best and worst over the last five years because the best will likely become worst and the worst will likely become best.

The analysis isn’t quite that simple, of course (nothing worthwhile in life is that easy), but some interesting data points can be gathered that might prove useful in guessing about the future.

For instance, the best performing sector over the last five years was precious metals (8.09% annualized).  That’s not at all surprising given that gold and silver have been on a tear over the last decade.  Will it be best going forward?  I doubt it.  I’d guess precious metals will continue to do well for a few more years and then tank.  Good luck trying to jump off the elevator before it plummets.

What else has done well?  If you guessed U.S. Treasuries, good for you.  They were the second best performing sector out of 103 sectors(!) with an annualized five year return of 6.99%.  If you think that one will be the best performing over the next five or ten years, please don’t operate heavy machinery.


The a
bsolute worst sector was short bias funds with a -16.61% annualized return.  It’s almost impossible to make money, long term, by going short all the time.  If the world falls apart, short bias funds will perform best over the next five years.  But, then again, you have to wonder whether property rights will be enforced or if the dollars you withdraw will be worth anything.

The Japanese stock market was the next worst sector, with a -13.27% return.  I’d guess that Japan is a very good candidate for a turn-around, but they culturally seem to scorn shareholders so I personally hesitate.  Unlike short-bias funds, I think this one has a good chance of looking brilliant in five or ten years.

The third worst was financial services (-11.09% annualized).  The crash and recovery from 2008 to 2009 makes that unsurprising, and a very likely candidate to out-perform over the next five years.  Like Japan, it has the clear ability to turn around, and everyone hates it, so it’s a great contrarian bet.

After looking at the best and worst stand-outs, I look at small versus large and value versus growth.  Anyone who has studied finance knows that, over the long run, small beats large and value beats growth.  The support and records behind that, both theoretically and empirically, are so strong and long that there is very little reason to believe it will change going forward.

However, the long term record also shows that small doesn’t–each and every year–beat large, and value doesn’t always beat growth.  In fact, long periods of time go by where just the opposite happens.  Such periods are usually followed by a snap-back to historic averages–and profit-making opportunities.

The last five years are very interesting along this dimension, because growth has crushed value and small has beaten large by a much larger margin than is historically usual.  This leads me to believe (and has for several frustrating years now) that value will greatly out-perform growth over the next five years and large will greatly out-perform small.

I’ll admit that I don’t invest with this approach as my starting point: I don’t examine the Barron’s tables and then go do research accordingly.  Quite the opposite, the Barron’s tables simply verify what I’ve been seeing in my bottom-up (security by security) research–that precious metals and U.S. Treasuries look very expensive, and that Japan and financials look very cheap.  It also confirms my experience that large companies seem to have much better return prospects than small, and that value looks much better than growth.

Barron’s report of five year performance isn’t a magic crystal ball, but it does provide some interesting information.  I think we’re likely to see a five year snap-back, and my fundamental research confirms that assessment.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Five year snap-back

Shifting tides

The stock market is frequently looked at as one amorphous whole.  It’s not.

Underneath the calm surface of aggregate stock market statistics are rip-tides of out- and under-performance.  Small companies beating large, value beating growth, foreign beating domestic, bonds beating stocks, commodities beating bonds, etc. 

What seems to surprise investors is how long these trends can last–years, not months.  Looking at 3 or 5 year performance, investors conclude that because foreign has beaten domestic for that long, it must continue.  Just the opposite is the case.

Mean reversion–the tendency of a prices to move back to average–is one of the most powerful forces in finance.  That which has performed best is likely to reverse over the long run.  Just when investors think the tide has gone out, it comes back in.

I believe this is especially the case today.  Specifically, small companies have trounced large over the last five years, bonds have crushed stocks, foreign has crushed U.S., and commodities have crushed…well…almost everything.  But, that which can’t go on forever, won’t.

In particular, I’ve been surprised at how well small has done versus large.  From April 1999 until December 2010, The Russell 2000 (representing small) has beaten the S&P 500 (large) by over 6% a year!  If that doesn’t sound like much, let me rephrase: it’s the difference between no return over 12 years and doubling your money!

Let me clarify: small usually beats large.  Small companies can grow faster and are more nimble, so it’s normal for small to beat large over the long run.  But, the margin is usually a little over 1% a year, not more than 6%.  It’s the difference between having 12% extra money and having over 100% extra. 

Now, this can not last.  And, it won’t.  Regression to the mean will cause large to out-perform small for several years until historical relationships are restored.  I can’t guarantee that, but it’s as close to a sure thing as you can get with investing.

When will the tide come back in?  I don’t know.  I was heavily invested in small companies from 2000 until 2004, so I enjoyed riding the tide out.  From 2004 until now, I’ve been shifting more and more from small to large in anticipation of the sea change.  What has surprised me is that I expected the tide to come in sooner (as it has historically).

Just because the tide seems to be going out more than I thought doesn’t mean I should try to ride it to the last.  Quite the opposite.  The smart thing to do is switch when it becomes prudent and wait for the inevitable.  I’m patiently waiting, and expect to be riding back in to shore soon enough.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Shifting tides