Last year was tough for some of our stock strategies. For example, we take a portion of our large cap portfolio and invest in ‘value’ stocks. Another, equally sized percentage is invested in a strategy that buys ‘momentum’ stocks.
I’m going to oversimplify here, but value stocks can be thought of as ‘cheap’ stocks. For a stock to be cheap, the market value of a company has to be low compared to its fundamental value – this usually occurs when there is some problem in a company or industry (think energy stocks today).
After a few years, the problem afflicting the company or industry has usually been resolved, so the stocks that were cheap tend to revert back to ‘normal’ market prices.
During that normalization process, value stocks tend to outperform the broader market. Over the long run, though certainly not every year, value stocks tend to outperform the overall market. More simply, on average, cheap beats expensive.
The other strategy, momentum, simply invests in the companies that have had good relative returns compared to other stocks.
The fund that we use in our large cap allocation follows an absurdly simple rule: rank the largest 1,000 companies in the U.S. by their most recent 12-month performance, buys the top third of the list and ignores the rest until the next ranking one month later.
Of course, neither strategy works all of the time. There are periods, whole decades even, when one strategy underperforms the market. For example, in the 1990s, expensive stocks soundly beat cheap stocks.
One of the reasons that we like both value and momentum is that the two strategies are negatively correlated with each other, which means that the extra return for investing in value stocks zig while the extra return for investing in momentum stocks zags. It’s often the case that when one outperforms, the other underperforms and vice versa.
You might ask, ‘Well Dave, if they offset each other, won’t they cancel each other out?’ It’s a good question, and fortunately, the answer is yes, sort of.
Both value and momentum have a history of higher average returns than the overall stock market. So although they do tend to offset each other some, what’s left over is still more than the market, on average.
Last year, though, the strategy didn’t work very well.
Value stocks, as measured by the Russell 1000 Value Index, gained 13.45 percent, compared to 13.68 percent for the S&P 500, a mild under-performance of -0.23 percent. The AQR Momentum index for large cap stocks didn’t fare as well, gained 11.19 percent, an underperformance of -2.49 percent.
Using these indexes, the value momentum combination earned 12.38 percent, an underperformance of -1.31 percent. Not terrible, but not what you hope for either.
Looking at the data, which goes back to 1980, the 12 months that ended in December ranked at about the 25th percentile, meaning that 75 percent of the time, the strategy had better performance relative to the market than last year.
On average, the value-momentum strategy outperformed by 1.16 percent across all 12-month periods since 1980. The best 12-month return ended in September 1993, when it outperformed by 16.96 percent and the worst 12-month return ended in November 2009, when it underperformed by -10.37 percent.
It’s normal to have periods of underperformance. If you want to outperform, you need to do something different than the market. You have to accept that sometimes, different will mean worse. Hopefully, over time, different will mean better, but that’s on average – some will be better, some will be worse, but on average, you should be ahead.
Thankfully, even though the results were in the lower middle of the pack, the magnitude of the under-performance wasn’t enormous.
To that end, all of this data assumes that we were 50/50 value/momentum in our large cap allocation, which isn’t the case. We have some money in the S&P 500 which doesn’t have any tilts and our individual stock names are a combination of value and quality – a whole different approach.
It may sound funny, but I’m not in the least bit concerned about the under-performance of the strategy last year. When we adopted the approach, we knew it wouldn’t work all the time – otherwise you’d have a magic money machine (like Bernie Madoff’s).
We always say that if you want extra return, you have to take extra risk. The underperformance last year is the realization of that risk. In our judgment, it seems like a small price to pay for attractive long-term performance.