A few canny value investors like Warren Buffett have beaten the market for decades by buying cheap shares.
More recently, academics noticed what they were up to and identified the value premium – the excess return over the market that you’ve earned by zeroing in on shares that looked cheap on measures such as price versus assets, or which sported a higher dividend yield.
Now passive investors like our own Accumulator are in on the act, adding a value tilt to their portfolios through ETFs that favour value shares over their growthier brethren.
But I think Mr. Buffett can probably rest easy.
Leaving aside my skepticism about recent attempts to reduce the legendary investor’s achievements to a formula, even data-driven academics concede that value investing is as much about emotion and temperament as it is about numbers.
Why? Because the worst companies in the value bucket often look one short lurch from the coffin. And even the best of them are seldom the sort of companies you’d brag about owning in a City bar.
It takes commitment to stick to value fodder when all else are abandoning dull companies for revolutionary electric car makers or sexy yoga pants vendors.
Indeed, even Warren Buffett found his market-beating record counted for little in the late 1990s. Buffett was ridiculed as yesterday’s man when he warned the financial world that the Dotcom bubble would end in tears. He refused to change his investing methods even as he badly lagged the market.
Of course, the 1990s stock market boom subsequently burst and Buffett was vindicated as his ‘boring’ stocks rose.
But in 1999 he wasn’t to know that would happen. He could only believe it.
European value versus growth
You and I also believe we’re made of the right stuff, right? Like Buffett, we’d have loaded up on value shares or funds in 1999 and concentrated on the long-term returns, wouldn’t we?
Well, I wonder.
We’re nearly all prone to behavioural quirks. Our minds are an orgy of competing biases that conspire to do in our best plans, whether we’re buying shares or trying to resist that fateful “one more” beer after work.
This is why the value premium persists. It should have been whisked away by the efficient market years ago, as it’s hardly a secret. Everyone should be buying value shares.
But like the poor and Bruce Forsyth, value is always with us.
Don’t believe me? Take a look at the following chart, which shows the performance of the iShares European Large Cap Growth ETF (Ticker: IDJG) versus the value one (IDJV) over the past five years:
European large cap growth versus value (click to enlarge)
As you can see from the graph:
- The blue line – the growth ETF – is up 20%.
- The red line – the value ETF – is down around 30%.
Growth has been smacking value for five years, by a 50% differential over the period.
How can this be?
Smokestacks on sale
If you look more closely at the graph, you’ll see the divergence began in early 2010.
This coincides with when bailouts for the peripheral European countries and even the break-up of the Eurozone went from nerdy financial columns to the mainstream nightly news.
Europe entered crisis mode, and people started to fear the worst. European markets fell, and some have yet to recover. The Italian market for example is still down by a quarter since the start of 2010, compared to the UK market that’s nearly 30% higher since then.
At first blush, the out-performance of growth companies compared to the value ones in Europe might seem surprising. Why would investors prefer to own more expensive growth shares if they were worried about the future? Wouldn’t it be better to focus on ‘safer’ value stocks?
It’s a sensible-seeming thought, but it’s not what happens. To understand why, you have to realize that ‘value’ as, say, Warren Buffett has popularised it, is not quite the same as an academic understands it – and hence not the same as you’d buy in a value ETF.
Early Buffett – or better yet hardcore value investors like Walter Schloss or John Templeton – did indeed buy baskets of beaten-down value stocks on the strength of cheap-looking company fundamentals.
But an older Buffett has warned us that the first rule of investing is “not to lose money”. And rule two refers back to rule one.
Stock picking value investors say they “focus on the downside”, too. What’s the most I could lose if my investment goes wrong? In the worst case, would anything be left if the company keeled over?
This sort of investment thinking – when applied to an economy headed into turmoil and recession – will often take you away from so-called value shares, and into growth shares.
I don’t mean flighty blue sky stocks with no real business to speak of. Such speculative shares are invariably decimated when bull markets end and recessions strike.
Rather, I mean good quality growth companies that look like making some progress whatever the economic weather.
Investors start to favour these stronger companies whose futures are more under their own control – ones where people really want to buy their products, and so they can to some extent control their margins and earnings.
An extreme example would be a company like online clothes retailer ASOS, whose shares are up 12-fold since 2009.
Recession, what recession? The compelling ASOS proposition has seen it take money off the many stagnant High Street retailers who’ve struggled as belts have tightened.
On the other hand, all the physical assets and stodgy revenues that define a value share are pretty onerous in a downturn. Sales fall as the wider economy stumbles, and profits can collapse. Production lines become a rusting liability. The company may theoretically have valuable factories or oil in the ground or what have you, but nobody wants much of that in a recession.
Value companies may also have big debts, which are about as attractive as concrete wellies on the Titanic when the economy darkens.
For all these reasons and more, value shares are often dumped in recessions.
Value isn’t just for Christmas
So value shares sell off, even though people know that if they buy and hold them for the long-term they’ll probably do better. And that’s just what has happened in Europe.
Interesting lesson, I hear you grumble. But how can we make money from it?
Well, the first thing to realize is that those European investors are no less smart than you or me. They have sold their value shares in the face of the storm, just as most of us will sell ours the next time things get rough here.
But more immediately interesting, perhaps, is that this could be a great time to go shopping for European large cap value shares.
I suspect most people invest in value on some sunny day thinking idly, “Don’t be silly – of course I will hold through the rough as well as the smooth!” They probably believe so, too, after looking at a few years of graphs showing excellent out-performance of value over growth to-date.
Sure they’ll see some glitch back in the midst of time, if they pan the graphs back far enough. Fine, they think – they’ll hold through a glitch. They’re no mugs!
Well, now we have a chance to buy value in the middle of the glitch – or just maybe as it’s coming to an end.
I’ve noticed over the past few months, European large cap value has kept the pace with growth:
European value versus growth over the past three months (Click to enlarge)
Moreover, I think the European economies are looking up, and long-term readers may remember I was always disdainful of the extreme break-up fears anyway.
When investors regain their confidence and those European factories start to hum, I’d bet good money Europe’s large cap value shares will close the gap and beat growth shares and the wider market.
In fact, I am betting good money.
US shares look a bit expensive, and even the UK looks a little heady in places, but European value shares look cheap.
So I’ve been buying in Europe – both in individual names and through European tracker funds.
And I’m taking a slug of that European value ETF, too. It’s yielding nearly 5%, and it’s packed with solid companies that will one day do the business again.
Academics take note: I’ll be available for interviews and your rigorous hindsight biased data-mining in a few years time! 😉
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European shares look relatively cheap in this forward PE chart too http://disciplinedinvesting.blogspot.co.uk/2013/07/equity-valuation-by-country.html (via abnormalreturns.com)
I’ve just had a look at the holdings of IDJV and 39% is within the finance sector. The same page on the website also states:
“This file represents portfolio holdings. The actual holdings of the product may differ.”
Looking at the top 10 holdings, this currently looks like a bet on banks regardless of the criteria used to identify “value” shares.
It’s a shame Vanguard don’t have an offering in this area with limits on individual share and sector holdings.
@Grumpy Old Paul — That is a weird disclaimer. Not at all worried about the bank holdings though. As I said, people go ‘yuck’ when they look at true value shares in the dumpster, so this isn’t unexpected, and banks make up a big swathe of most indices anyway. (I have been a big believer in a banking recovery in the US/UK for the past 2-3 years and have held between 3-6 different individual names at any one time over the past year or so, but belatedly I realised I was probably actually underweight versus the market weighting of banks most of that time, especially in the UK! Doh!)
Even European banks are more likely to post a return higher than the market over the next five years than lower over say five years, in my view. Black Swans nothwithstanding.
I might just wait for the German elections to pass, and whatever turmoil follows in the six or nine months after that.
Come to think of it, is there an ETF that does Bunds?
Funny old game, isn’t it. I’m firmly of the opinion that the euro is going to blow sky high at some point, but some of these big European firms are still not going to go bust whatever they are filing their accounts in. I’ve been buying Europe as an index ETF over the last year or so.
Europe is mad, bad, and dangeorous. But interesting. The European ETF had the temerity to rise over the last year, which isn’t what I had expected, but I think that’s more to do with currency and the good ole BoE than any stupendous rise in European fortunes. Which is another story, it’s hard to tell performance from sterling depreciation these days…
I bought into European via a couple of heavily discounted ITs (JEO and HEFT) and benefited nicely as the discounts narrowed and the NAVs soared once it became clear that they’d “do all it takes” to keep the Eurozone together.
I’ve now sold these but still hold some ETFs and even (gasp!) a fund to keep me slightly over-weighted in Europe. I also still hold TR Property.
If you are looking for value you would be buying in emerging markets and Asia as well as Europe
I recently rebalanced my ISA portfolio switching it into Vanguard ETFs putting 25% of it into Europe (including the UK though) and 30% emerging markets/Asia. We’ll see how that works out :/
I trimmed back my US exposure a little but I expect that I will regret that I wasn’t more bold in the course of time
@The Investor,
You’re a braver man than I. But that’s not saying very much!
However, one could argue that it is not surprising that an ETF invested so heavily into banks has underperformed a growth ETF during and following the credit crunch. Five years ago, August 2008, after all was after Northern Rock and Bear Stearns but before the Federal take-over of Freddie Mac and Fannie Mae and the collapse of Lehman brothers.
On a long term view, one can argue that if one does not believe in economic Armageddon, at some point there will be a real recovery and return of confidence and bank shares will recover to previous values. Most of the posters of comments on Shaun Richards’ economics blog over at Mindful Money are unremittingly pessimistic, especially about Europe.
Presumably a European ETF will also expose you to some currency risk too. But you might argue that the risk is only on the upside!
@Ermine
Currency matters a lot, maybe as much as a third off or on your total annual returns
Japanese shares’ rise doesn’t look nearly as impressive measured in sterling
By contrast the US’s rise looks very in nice sitting over here
I’m not basing that on anything more scientific than looking how much my funds have moved up and down since Christmas
Difficult to call banks a value share on a price vs assets basis if you don’t understand a bank’s balance sheet.
Banks’ balance sheets are hard work for even those practiced in the craft. For instance, look how wrong KPMG were about the Coop!
Do you protect your international holdings (in Europe or when they are hold in any currency other than sterling) somehow?
I don’t know how much a currency movement can affect the total return, but it could make the final return quite different to what we might expect if we were investing in our local currency?
@Tronader — I don’t hedge (or protect, if you prefer) my international holdings, no. The research (Dimson and others) has shown that there’s not much benefit in hedging equities if you’re a long-term investor across a good range of currencies, basically because the swings and roundabouts average it out over time, and because companies may, say, benefit from weaker currencies, which in turn boost their stock prices.
(It’s different if you’re investing in fixed income (i.e. bonds or cash)).
Also, hedging has a cost, whether overt or hidden. If you could literally tick a box and take currency out of the equation perhaps I sometimes would, but you can’t. So I treat currency risk as another valuable source of diversification.
Finally, hedging is arguably taking an active view on a currency. i.e. “This could go against me, therefore I should hedge”. But the currency could equally well work in your favour. Currency trading is notoriously hard and unpredictable. I certainly have no edge, so don’t generally try not to get involved in having a view.
Absolutely it will impact my returns, though.
In my view anyone who thinks they can fully understand a mega-bank’s balance sheet is deluding themselves. That goes for bankers, too. The CEO can understand the big picture, but he has to devolve understanding (and responsibility) throughout the organisation.
So how to value? Well, the bank gives us a stab in the dark. It’s net asset value aka book value. In confident, bullish times, this book value may be wildly overstated, and you’d be wise to apply a discount.
In times like today, when banks have been scrutinised for 5 years and everyone “knows” they are risky, it’s likely to be pretty conservative, in my view. Economic conditions may keep eroding it, but it’s probably not plucked from entire thin air in the first place or based on hollow or flimsy assets, as seemed to be happening pre-2007 in some cases.
When you buy a bank like Barclays currently, you’re getting a further margin of safety, in that it’s priced at a discount to that book value. In the “good old days” it might have traded at say 3-times the book value! Quite a difference.
Finally, I look to management and culture. These are the guys you need to trust as best you can (and I don’t trust bankers as a rule). Before the crisis, I owned Lloyds and Standard Chartered for this reason. Both were valid picks, but Lloyds as we all know blew itself up with its merger with HBOS. Those were crazy times though. I think the new CEO is excellent.
In the US I like many of the new managements, in contrast to before. Dimon (JP Morgan) is the pick of the bunch, but ironically I hold no JPM shares. I do currently own Wells Fargo, Bank of America and a sliver of CitiBank when it comes to the US.
In the UK after a few false starts I eventually did very well indeed out of Lloyds. Standard Chartered did well but I botched my gains trying to be clever trading. I have bought Barclays after the recent rights issue announcement. In Europe I own Santander.
Nothing is certain in investing, but I am pretty confident it’s better to be buying these banks now half the investing world won’t look at them than in 2006 when they were touted as shares for widows and orphans.
@Grumpy Old Paul — The big declines in European banking stocks (and others) came as I say in 2010. Before then, European banks had managed to convince the world / regulators that they were safer and doing better, compared to the US where the authorities kicked everyone out of the C-Suite, recapped, and started again. Arguably that’s why it’s all dragged on so long in Europe.
I’d ignore any unrelenting pessimists. We have one or two here (an infamous one on this thread! 🙂 ) but if I saw a lot of them I’d start deleting their comments. I can’t think of anything worse than creating another Internet watering hole for money-sucking doom-mongers.
You’re definitely not guaranteed to do well investing because you’re an optimist, but very few pessimists ever got rich in the stock market, (assuming they actually practiced what the preached).
Sure a few shorted sub-prime bonds etc and I couldn’t be more impressed by that call, but some of the best of them (e.g. Burry, Paulson) were buying financials and housing stocks just a year or two later.
In contrast, if all the Internet perma-bears got together every day they believed they could almost wish away the doubling in the stock market etc.
I’m sure many of these people are perfectly fine citizens in real-life, but they are terrible at understanding investing, markets, economies, human incentives, biases, and much else, as far as I’ve observed.
The only bank I held going into the CC was HSBC (phew!), but I’ve since bought small amounts of LLOY, STAN and RBS with moderate success and I’m looking to hold these long term.
Following your article, I’m quite attracted to something like the iShares Euro divi ETF with its exposure to continental banks, so I may buy that next week. I don’t really pretend to understand bank balance sheets, beyond the fact that they are about small differences between big numbers and, hence, subject to volatility.
Nicely put, TI. I’m all for investing in places I guess others have an irrational fear for. That’s why I currently like tech and Japan – enough people have got burnt over a long period of time to put them off permanently!
Thinking about this quote:
“When you buy a bank like Barclays currently, you’re getting a further margin of safety, in that it’s priced at a discount to that book value. In the “good old days” it might have traded at say 3-times the book value! Quite a difference.”
Considering the book value was immensely overstated then, that’s even more remarkable! What worries me is how much dross is still lurking there, even now. Not enough to really care though – I don’t pick stocks or even really sectors…
i expect the net asset values of banks are less overstated than they were a few years ago, but i’m not so sure that they’re actually understated.
i know that the usual approach of companies after a disaster is to declare “kitchen sink” losses – i.e. take provisions for everything that could possibly go wrong, so that from then on, all news will be good news.
but what if following that approach would make the banks insolvent, or just have unacceptably low reserve ratios? wouldn’t they declare the losses more gradually, so that (a) the next few years’ profits can cancel out some of the losses and (b) if they need to raise more capital, they can raise it in several tranches? given the opaque (i.e. misleading) nature of banks’ accounts, i don’t see how this possibility can be ruled out.
a phased raising of minimum capital ratios is pushing the banks into a series of new issues of capital. which would be very convenient for them if they would like to increase their capital in order to cover anticipated losses. regulatory capture?
this is all intended to argue that we don’t know whether banks are good value currently, not that they aren’t good value.
the value premium is fine in theory, but 1 of the problems is that it depends on the reliability of figures in company accounts e.g. book value. (well, unless you define value based only on dividend yield.)
i’m not quite compfortable with using mechanical strategies for value. i don’t feel i have a full grasp of the risks, though this may well be my lack of understanding.
i’m much more comfortable using the active management of aberforth smaller companies, knowing that the management has a long-term strategy of focusing on value (in UK smaller companies). you’ve mentioned aberforth on monevator a few times. are there similar options for other markets?
@ggs
Take a look at the Dimensional funds for a value focus. Traditionally advisor only, they are now coming to a few platforms. (e.g. TDDirect)
(Good theory btw, and one I agree with.)
@The Investor. Many thanks for the explanation of your point of view regarding investing in a different currency and the link to the related topic. Loads of useful information in all the posts you’ve written about the subject!!
Thanks again…
Investing in Europe seem’s to be doing the rounds in the media at the moment. Therefore is it really still the right time to be doing so?
Kind regards
Grand
I blame the Reformed Broker 😉 http://www.thereformedbroker.com/2013/08/07/western-europe-as-the-new-emerging-markets/
Agree but I think I was just ahead of the trend with this and even more so with my buying (in fact I sometimes wonder if the media read this blog — delusions of grandeur! 😉 )
I wanted to add a property ETF to my portfolio but have opted out because of the transaction costs associated with CSD unless I decided to wait 3 months where the volume of shares bought would make it worthwhile. I was considering buying into Europe as a substitute could you recommend some alternatives to the Dimensional Fund available through CSD?
Kind regards,
Grand
While there may be cheaper/snazzier alternatives around, in practice I’d just look at the range from iShares, which is pretty comprehensive. You can buy growth orientated, value orientated, and size factored ones there, all non-synthetic etc. I’d not suggest one over another to you though, that’s for you to decide based on what you’re trying to achieve.
@PC — Yes, he’s been pushing the theme on CNBC, too. (Guilty secret out again). I’d note his post came three days after mine, though. 😉