One consequence of the financial crisis has been number inflation.

I don’t mean the everyday cost of living inflation that measures how your shopping basket becomes more or less expensive from year to year (although such inflation is ahead of target, and many fear worse).

Rather, I mean how the numbers you read in news reports are far more ginormous than ever before.

Remember when a million meant something? Even a billion got a bit of respect before the credit crisis.

Nowadays it takes a trillion to make anyone sit up and pay attention.

Newsreaders dismissed the GDP of an economy like Cyprus – $24 billion – as embarrassingly tiny. They seemed almost offended by the clumsy way the Eurozone handled that crisis. Why couldn’t it have just chucked a few billion Nicosia’s way, and saved us all a lot of bother?

A 10 euro billion bailout? Pah! Wake me up when there’s a real crisis.

Mind-bogglingly massive debts

Our complacency about not-so-big-but-actually-still-very-big numbers may yet prove to be misguided. The Archduke Ferdinand was just one man, but his assassination still plunged Europe into World War I.

I’m thinking today though about the opposite problem – the way behemoth numbers are thrown about or plotted onto graphs to terrify and confound.

You see this a lot with the national debt of the UK and US economies. When you hear the gigantic amount we will need to repay in future years, it’s tempting to spend whatever resources you’ve got now on a wild bender in Brighton before throwing yourself off the pier.

Don’t be so hasty!

Let’s look at the US situation, where the numbers are especially massive, and where constant rankling among US politicians keeps those numbers in the news.

As every numerate American schoolboy knows, his country’s national debt is approaching $12 trillion.

But how many know that the GDP of the US is $15 trillion? Or that as of the end of 2012, the household wealth of the citizens of that country was estimated at $79.5 trillion, versus liabilities of $13.5 trillion?

Net those figures out and the US populace has a net worth of $66 trillion.

The US is staggeringly rich, even if you also tack on the national debt.

Yet how often do we hear it’s bankrupt?

The law of crazy big numbers

I postulate a new law for the economic textbooks:

The Investor’s Law of Crazy Big Numbers: Whenever there is a chance to use one side of the balance sheet to shock and awe the audience, be sure you ignore the other side. And better yet forget to mention anything about revenues and income – as well as the fact that in 30 years time we’ll all very likely be far richer, not least through inflation, which will make some of today’s large numbers seem a mere bagatelle by tomorrow.

My point is not that the US – or the UK – should duck getting its house in order.

Ultimately, the Micawber Principle applies, even in the realm of Crazy Big Numbers. Income and outgoings must eventually be brought into line.

But would you say a 30-something couple with a joint income of £150,000 a year, a house worth £1.5 million, and a mortgage of £500,000 is in financial dire straits?

Of course not, and neither is America.

Number crunched

I hope you will remember to look at the big picture the next time you stumble across an insanely-bearish blog that’s predicting global collapse on the back of some very large number or another.

Who knows, I don’t expect it but we might collapse. Even I’d make an each ways bet on environmental catastrophe.

But it won’t be because of the tricks that large numbers play with our minds.

Loading up on the value premium is the financial equivalent of exploiting the sick and the weak. You’re putting the returns of vulnerable companies to work in your portfolio.

Why? Because in the past they’ve proved capable of delivering better results than glamorous growth stocks such as Facebook or Apple.

This extra return available to investors is known as the value premium and it’s one of a suite of return premiums that can power up your portfolio.

But it’s completely counter-intuitive. How can a spluttering firm possibly hope to outshine a trailblazing company whose brilliant ideas are catching fire across the globe?

Well, it’s important to understand we’re not talking about pitting some ailing local newspaper group in a mano-a-mano pit fight with Google.

What we are saying is that the relative average performance of ‘value’ companies has been better than ‘growth’ companies, as a group and over long periods of time.

Why should that be?

There are two main explanations as to why value companies outperform.

One is that investors tend to overpay for growth companies. They get overexcited about the possibility of discovering the next Google and so shell out too high a price for the golden ticket.

Many growth companies don’t live up to their billing and, as a group, they can’t generate the returns that justify their high valuations. In comparison, value companies are underrated. They thus have the potential to bounce back.

The other explanation is that investors wrinkle up their noses at the stench of decay lingering around value companies. They know value companies are risky. Rightly enough, they want to be compensated for taking on that risk with the prospect of a higher expected return.

Value companies have to go cheap in order to entice investors. Think of the bargain shelf in the supermarket full of battered and bruised products at knockdown prices.

How do I spot a value company?

A value company generally has a low market price in comparison to a series of stats that measure its financial health. These stats are often described as a company’s fundamentals.

A value company will have a low price in comparison to its:

• Earnings (expressed as the Price to Earnings ratio or P/E)

• Book value (P/B ratio)

• Dividends (P/D ratio)

• Cash flow (P/CF ratio)

• Sales (P/S ratio)

Lower ratios can indicate that a company is undervalued and so could turn up trumps if its situation improves.

Equally, the subdued prices warn that the company is wobbly.

Value companies are often characterised by high debt levels, volatile earnings, and volatile dividends. They are particularly likely to be punished in times of recession, when they lack the agility to respond to worsening conditions because they:

• Struggle to innovate.

• Can’t easily ditch surplus capacity when demand goes south.

• Are highly leveraged so aren’t exactly favourite for new loans to bail them out.

Risk story

All this is why there’s very real risk attached to investing in value companies.

Although you can diversify away individual company risk by investing in a fund or ETF, value companies as a whole can get pummeled for protracted periods.

• In the US, the value premium was negative for 12 years between May 1988 and October 2000.

• Its annual volatility has been around 14% per year (in the US) so a value investor has to be able to live with trailing the market.

• On the upside, the value premium has averaged 4.9% per year between 1927 and 2010 in the US.

• The premium was 3.6% in the UK between 1956 and 2008.

These numbers explain why some investors, including me, are persuaded by the research to devote at least some – perhaps 10% – of their equity allocation to passive funds that follow a value strategy.

But beware, the value premium has been negative for four of the last five years between 2007 and 2012 (in the US).

There’s no guarantee that the premium will perform well – or even persist – into the future. That’s the risk for which we hope to be rewarded.

Take it steady,

The Accumulator

Good reads from around the Web.

A research company called Mebane Faber wins my lesser-spotted post of the week award this Saturday for You are not a good investor, its disassembling of the vanities of stock pickers.1

First, the article calls up a fascinating study – The Capitalism Distribution – which examined stock returns from the top 3,000 stocks in the US from 1983-2007 and found:

• 39% of stocks were unprofitable investments

• 19% of stocks lost at least 75% of their value

• 64% of stocks underperformed the index

• 25% of stocks were responsible for all the market’s gains

Mebane Faber notes:

Simply picking a stock out of a hat means you have a 64% chance of under-performing a basic index fund, and roughly a 40% chance of losing money.

Ah, but we stock pickers have no use for a hat! We select shares carefully!

Sadly, whatever I think of my skills and whatever you know about yours, we can say with certainty that most people are terrible at managing an active portfolio.

This is brutally shown in a follow-up chart from Business Insider, which uses data from BlackRock and the famous Dalbar Study of investor returns:

Incidentally, check out the return on homes.

I told you guys homes have been better investments for most people, but you insisted on making it into a debate about house prices… 😉

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1. Full disclosure: I am such. For my sins. [↩]