Nothing Works All of the Time

One topic of fairly regular coverage in the financial press these days has been the underperformance of value stocks relative to their growth stock counterparts. As the table presented below demonstrates, U.S. value stocks (Russell 1000 Value Index) have underperformed growth stocks (Russell 1000 Growth Index) thus far in 2019 and over the last 1, 3, 5 and 10 years as of April 30.

As steadfast believers in the efficacy of value investing over the long-term, value’s recent underperformance is certainly disappointing. However, while it’s absolutely natural to be disappointed in short-term underperformance, it’s paramount that we also recognize that short-term underperformance is not at all unprecedented.

A recent research piece from Dimensional Fund Advisors helps to illustrate this reality. In their commentary, Dimensional’s researchers examined the historical data to assess how frequently four empirically well-documented premiums have delivered negative performance over multiple observation horizons going as far back as the data allowed.[1] The four premiums observed were the market premium (the tendency for stocks to outperform cash or treasury bills), the size premium (the tendency for small cap stocks to outperform large cap stocks), the value premium (the tendency for value stocks to outperform growth stocks), and the profitability premium (the tendency for stocks of highly profitable companies to outperform those of low-profitability stocks). The chart below shows the frequency of realizing a negative premium (i.e., underperformance) in U.S. markets over rolling 1-, 5-, and 10-year periods.

 [1] “Perspective on Premiums” Dimensional Fund Advisors.

The chart clearly demonstrates that negative premiums occur periodically, even over periods as long as 10 years. For example, we can see that value stocks have underperformed growth stocks in 16% of the rolling 10-year periods observed dating back to 1927. Interestingly, this figure is within spitting distance of the frequency with which the market as a whole underperformed riskless treasury bills over rolling 10-year windows (15%).

Additionally, an astute observer will notice that the odds of realizing a negative premium noticeably decline as the observation period is extended. Put differently, an investor increases their chances of realizing a positive premium by maintaining a longer investment horizon.

Dimensional’s researchers took their analysis a step further and sought to answer a natural follow-on question: how have these premiums historically performed following a 10-year stretch of underperformance? To answer this question, the researchers identified the rolling 10-year periods where a premium was negative and then observed how the premium performed over the following 10 years. The table below shows that performance for the market, size and value premiums have historically tended to be quite strong after periods of extended underperformance.

Value stocks, for example, have outperformed growth stocks by an average of 8.31% per year over the next 10 years after a 10-year period of underperformance. The comparable figures for the market and size premiums historically are 8.19% and 4.64%, respectively. It’s important to note that the data shows a wide range of outcomes for all of these figures underscoring that range of uncertainty that exists in investing.

Ultimately, while value’s recent stretch of extended underperformance is disappointing, investors would be well served to recognize that periods of underperformance are not unprecedented in the historical record and that such periods have tended to be followed by extended periods of strong performance, on average.

IMPORTANT DISCLOSURES

Past performance is no guarantee of future results.
Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio.
All performance referenced is historical and is no guarantee of future results.
No strategy assures success or protects against loss.
The opinions voiced in this material are for general information only and are not intended to provide or be construed as providing specific investment advice or recommendations for any individual security. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.
The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
All investing involves risk including loss of principal.
Investing in stock includes numerous specific risks including: the fluctuation of dividend, loss of principal, and potential liquidity of the investment in a falling market.
Value investments can perform differently from the market a whole. They can remain undervalued for long periods of time.

Securities offered through LPL Financial, Member FINRA/SIPC. Investment advice offered through Private Advisor Group, a Registered Investment Advisor. Private Advisor Group and Kathmere Capital Management are separate entities from LPL Financial.