In this three-part series on market anomalies, Tyndall Australian equity portfolio managers, Jason Kim and Tim Johnston explore how investors can tap into what they believe are three consistent sources of outperformance in equity portfolios: Value investing; lower beta portfolios; and concentrated portfolios.
Background
Many empirical studies have shown that a value style approach to share investing has consistently outperformed growth investing – and with less risk. Other studies have shown that lower volatility portfolios, particularly lower beta portfolios, outperform higher beta portfolios. Concentrated equity portfolios have also proven to outperform their more diversified counterparts.
If value, lower beta and concentrated portfolios have consistently outperformed in the past, then isn’t it only a matter of time before investors arbitrage this away? If this was true, then these ‘anomalies’ should have disappeared a very long time ago as they have been documented for many years. In fact, these so called ‘anomalies’ are a permanent feature of share markets.
This article looks at the first anomaly – value investing.
Value has outperformed growth in the long term
There have been many studies on various equity markets which show that value has consistently outperformed growth. Typically, these studies defined value stocks as those with low ‘Price to Book’ ratios or in some cases low ‘Price to Historical Earnings’ ratios. It is also likely that this ‘anomaly’ will continue to persist in the future.
Among these empirical studies include Basu (1977), De Bondt & Thaler (1985) (1987), Lakonishok & Vishny (1994), Fama & French (1992), and Arshanapalli, Coggin & Doukas (1998).
Of course, this fact would come as no surprise to the many famous value investors, such as Warren Buffett and John Templeton, who have enjoyed enduring success with their share investments.
Australian market style indices produced by S&P/Citigroup, show that during the period October 1989 to January 2014, value investing in Australia has outperformed growth investing, as has been shown for the global share market. (NB. This is the longest period we can obtain for Australian market style indices.)
During this period, value produced a return of 10.87% pa, while growth produced a return of 8.87% pa. This means that value outperformed growth by 2.00% pa. In dollar terms, if $100 was invested in the S&P/Citigroup Value Index during this time period, it would have accumulated to $1,221 by January 2014, whereas for growth, the amount would have been materially lower at $786. Returns are before fees and taxes. Past performance is not an indicator of future performance.
Background
Chart 2 shows that during any 3-year time period, on most occasions, value has outperformed growth quite handsomely in Australia, as has been the case for global shares. The key exception was during the unprecedented commodities and resources boom that fuelled economic growth in Australia for almost 10 years from 2003. This was driven by the rapid industrialisation of the most populated country in the world, China and in turn saw growth stocks outperform value stocks.
A cynic may argue that the only reason why value outperformed growth is because value shares are riskier than growth shares. Many value investors would totally disagree with this statement, and would argue that value investing is actually less risky than growth.
Most value investors would argue that they pay 60 cents for something that is worth $1, and as such there is good margin of safety in the investments they undertake.
One measure of risk is the volatility of returns as measured by the standard deviation of returns. As table 1 shows, value has been less volatile than growth with a standard deviation of 13.51% versus 14.27% for growth.
Another measure of risk is beta, which is essentially a measure of market risk and strips out the impact of stock-specific risk which can be diversified away. As table 1 shows, value has had less market risk than growth with a beta of 0.968 versus 1.028 for growth.
This analysis thus shows that not only has value outperformed growth by a significant margin, but it has done so with less risk.
Comparable numbers for global equities using the MSCI World Value/Growth Index, which co-incidentally has a longer history (January 1975 to January 2014), are provided in table 2. It should come as no surprise that the numbers for global equities tell a very similar story. Value has outperformed growth by 2.08% pa over the period and with lower risk with a standard deviation of 14.81% (versus 15.75% for growth) and a beta of 0.966 (versus 1.031 for growth).
How significant are these findings?
One way to measure the significance of a result, is to calculate a t-statistic. In this case, we need to test how confident we can be that value will continue to outperform growth in the future. To do this, we need the historical outperformance of value over growth, the standard deviation of this outperformance, and the number of observations. Naturally, the greater the sample size, the more significant will be the result. The formula to calculate the t-statistic is provided below:
T-statistic = (outperformance/standard deviation of outperformance) x square-root (no. of observations)
As a general rule, a t-statistic of at least +1.0 is considered to be meaningful and +2.0 is considered be highly significant. At +2.0, it implies at least a 98% probability that this ‘anomaly’ will persist in the future.
For Australia, the China-driven commodities boom has had a marked impact on the results, but despite this, we have a moderately meaningful result. With a t-statistic of +1.4 (as shown in table 3), this implies a 92% probability that these performance and risk results will persist.
Can this anomaly continue? Overall we can be confident, at least from a statistical perspective that value will continue to outperform growth in both of these share markets.
Part 2 of this three-part series will focus on the second anomaly: lower beta portfolios outperform higher beta portfolios. It was also delve more into our reasons why we believe both of these anomalies will persist in the future.
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Disclaimer: This document was prepared and issued by Tyndall Investment Management Limited ABN 99 003 376 252 AFSL No: 237563 (TIML). The information contained in this document is of a general nature only and does not constitute personal advice. It is for the use of researchers, licensed financial advisers and their authorised representatives. It does not take into account the objectives, financial situation or needs of any individual. The Tyndall Australian Share Concentrated Fund (TASCF) ARSN 143 598 556 is issued by Tyndall Asset Management Limited ABN 34 002 542 038 AFSL No: 229664 (TAML). Investors should consult a financial adviser and the information contained in the current Product Disclosure Statement available at www.tyndall.com.au before deciding to invest. Reference to individual stocks in this material neither promise that the stocks will be incorporated into TASCF nor constitute a recommendation to buy or sell. TIML and TAML are part of the Nikko AM Group.
