The last two years, and in particular the 2015 calendar year, global financial markets have been in “risk-off” mode, with investors concerned about the lack of economic growth around the world, including Australia.

Stocks that have performed well during this period had the following attributes:

1. High return on equity (ROE) – considered to be a proxy for “quality”
2. High earnings per share (EPS) growth – considered to be a proxy for “growth”
3. High dividends per share (DPS) growth – considered to be a proxy for “defensive growth” stocks.

In a “risk-off” environment, typically the focus on valuations falls by the wayside and many investors chase “safety” at any price.  In this environment, growth and quality managers tend to perform well, while value managers typically underperform.

The chart below looks at the various financial markets around the world (including credit and equity markets) to assess whether the markets are assuming “the world is over” or “everything is rosy” scenario. This is about the psychology of investors, where fear and greed can drive markets, and where disciplined value investors can take advantage of this over time (although the timing may not be perfect).

As chart 1 shows, fear or “panic” has dominated financial markets in the first few months of 2016. These extreme moments of fear and greed (“panic” and “euphoria”) do not last long, and eventually revert.

During periods of fear, investors chase quality, defensive growth and earnings growth at any price and drive valuations of these stocks to extreme levels as they are regarded as a safe haven, while shunning the rest of the market. These perceived ‘safe’ stocks can be driven so high in value that they become ridiculously expensive and even ’risky’.

Last year in particular saw this trend reach extreme levels (as shown in the following charts).  Value managers have underperformed during this time, while growth managers have performed very well.  However, we believe we could see this trend reverse soon.

Chart 2 shows the Price to Earnings (P/E) multiple of the stocks that offer dividend growth (eg Sydney Airport, Transurban, APA) relative to the market average.  These stocks are seen to be high quality with growth in cashflows irrespective of economic growth.  There is a price for everything, but they are trading at extremely lofty multiples.  We acknowledge they are good-quality companies, but they are incredibly expensive and are trading at extreme levels which look difficult to sustain.

Chart 3 shows the same P/E relationship for those stocks with earnings growth (eg Dominos, Bellamy, Blackmores) and again they are trading at extreme levels – some are trading at around 60 times earnings and are priced for perfection as investors assume extraordinary growth over the next few years. The slightest disappointment will most likely see these stocks sold off heavily.

Similarly, chart 4 shows the P/E of ROE stocks, which is a proxy for “quality” stocks. This could include stocks already discussed above, but more generally are those companies that produce good earnings from limited capital outlay.  Again they are trading at extreme P/E levels.

Value stocks have taken a beating

Value stocks are currently those “beaten down” stocks in industrial cyclical industries where earnings and/or the outlook have been impacted by concerns about the economy either locally or globally.  We currently see incredible value in industrial cyclicals.  Examples include Incitec Pivot, Fletcher Building and CSR.  In addition, many parts of the Financials sector (excluding REITs) now look very cheap, again due to concerns about the economy as well as financial markets (obviously related to each other), and they include the banks, Lendlease, Henderson and IOOF.  We have recently been buying more of the banks and moved from an underweight to modestly overweight position.

The banks as a group (especially ANZ and National Australia Bank (NAB), and to a lesser extent Westpac) look very cheap and are trading at extremely low PEs relative to their respective historical levels.  ANZ is at a 3 standard deviation low, NAB is trading at a 2 standard deviation low and Westpac is trading at over 1 standard deviation.  The markets are jumping at shadows and the banks have been easy targets (up until recently) on concerns about China and concerns that the housing market will collapse, which have been exacerbated by highly-sensationalised media reports.

We often talk within our team about how the markets have forecasted seven out of the last four recessions.  The markets will sometimes think the sky is falling in, but underestimate the will and the tools that central banks and governments around the world have to help address these concerns when they arise.  Australia survived the global financial crisis relatively unscathed, but the equity markets had priced in quite the opposite scenario.  Equally, concerns about Greece were overblown in 2011, with the European Central Bank implementing a host of policies to ensure that there would be limited contagion.

Looking ahead, we believe that not only will the Australian equity market be more constructive, but we also see the scene being more conducive for a snap back to value. Many empirical studies have shown that value investing has consistently outperformed growth investing over the long term – in both Australian and global equity markets. Our own analysis (Re-visiting the age-old debate on value vs. growth investing) shows that in the Australian equity market, value outperformed growth investing by an average of around 2% pa since 1989 (as at 31 October 2015) – and with less risk.

By Jason Kim, Portfolio Manager & Senior Analyst, Nikko AM Australia

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Disclaimer: This article was prepared and issued by Nikko AM Limited ABN 99 003 376 252 AFSL No: 237563 (Nikko AM Australia). Nikko AM Australia is part of the Nikko AM Group. The information contained in this material is of a general nature only and does not constitute personal advice, nor does it constitute an offer of any financial product. It is for the use of researchers, licensed financial advisers and their authorised representatives, and does not take into account the objectives, financial situation or needs of any individual. The information in this material has been prepared from what is considered to be reliable information, but the accuracy and integrity of the information is not guaranteed. Figures, charts, opinions and other data, including statistics, in this material are current as at the date of publication, unless stated otherwise. The graphs, figures, etc., contained in this material include either past or backdated data, and make no promise of future investment returns, etc. Past performance is not an indicator of future performance. Any references to particular securities or sectors are for illustrative purposes only and are as at the date of publication of this material. This is not a recommendation in relation to any named securities or sectors and no warranty or guarantee is provided.

The post Value investing set to snap back? appeared first on AdviserVoice.

Background

Australia’s demographic shift is having a significant impact on Australia’s financial markets. The search for income in a low interest rate environment has seen investors, particularly the rapidly growing self managed superannuation funds, develop a love affair with high-yielding stocks.

With bond yields expected to stay at relatively low levels, the demand for high-yielding equity strategies is likely to continue. Investing in just a handful of traditional high-yielding blue chip stocks and holding onto them, may however expose investors to greater volatility than they are prepared for. An actively managed portfolio, comprising a diversified selection of traditional and non-traditional high-yielding stocks that are continually assessed for value, can help reduce this volatility.

How has Australia’s population changed?

Over the past 100 years or so, Australia’s population structure has changed markedly. In 1911, it was a typical pyramid shape – bottom heavy with the population skewed to younger age groups. By 1961, the pyramid had widened reflecting the growth in Australia’s population, particularly in the 0-14 age bracket, reflecting the birth of the baby boomers post World War 2.

By 2004, the pyramid had changed shape altogether, particularly around the middle, with the baby boomers now aged in their 40s and 50s. By 2051, the Australian Bureau of Statistics (ABS) is projecting Australia’s population structure to be more top heavy, with people aged 80 plus representing a significant percentage of the population – more than those being born (ie 0-4 years of age).

What’s causing the change in shape?

In addition to the ageing of the baby boomers, increasing life expectancy is another contributing factor causing the shift in Australia’s demographic structure. According to the ABS, the average life expectancy for females born between 2010 and 2012 is 84.3 years of age, up from 58.8 for those born just over 100 years ago in 1910. The average life expectancy for men is 79.9, up from 55.2.

A lower fertility rate is also playing an important role. Australia’s fertility rate has fallen sharply since the early 1960s. A fertility rate of 2.0 (ie two children) is considered to be the replacement rate for the population – two children replaces two parents. Australia’s fertility rate has been below 2 since the mid-1970s.

Should we be concerned?

While the 65 plus age group as a percentage of the total population is expected to increase to 27% of the population by 2050 (from 15% currently), of greater economic significance is the forecast decline in Australia’s ‘inverse dependency ratio’. The ratio of the working age population to dependents (defined as those aged less than 15 years of age and 65 plus) is expected to fall from around current levels of 2 to 1.5 by 2060.

A shrinking working age population has significant implications for the Australian economy and the share market.  An ageing population places a financial burden on the economy through higher demands on public healthcare costs and social security from retirees; while tax revenue and consumer spending is dampened due to the lower proportion of the working age population.

Japan has experienced the demographic shift already and in a more pronounced manner due to negligible immigration, persistently low fertility rates and rising life expectancy. Currently, Japan has 25% of its population aged 65 plus. Over the last several years Japanese investors have been seeking high-yielding investments around the world due to low interest rates and an ageing population seeking higher income than what is available in their own country. The Australian equity market has been a beneficiary of this demand.

What impact are SMSFs having?

The rise in grey power is impacting the Australian share market quite significantly via the growth in self managed superannuation funds (SMSFs). According to the Australian Tax Office and Credit Suisse, SMSFs received an average of around $15 billion per financial year in net inflows over the nine-year period from 2003-04 to 2011-12.

What’s concerning, is that SMSFs appear to have a distorted asset allocation with a significant bias to direct domestic equities and property.

Anecdotal evidence suggests that the direct equity exposure is limited to the big four banks and a handful of blue chip high-yielding stocks. What’s more, SMSFs are continuing to buy these stocks, regardless of value or where we are in the market cycle.

The boards of companies are becoming increasingly aware of the growth and influence of SMSFs and their increasing demand for higher dividends.

As noted above, the demographic shift will potentially lead to lower economic growth. This, together with the increasing demand for higher dividends by SMSFs could exacerbate this problem as companies feel pressured to meet their demands – at the expense of investing in their businesses.

Does this mean dividend yield strategies will continue to outperform?

This demand for high-yielding equities has obvious implications for yield-driven strategies. Over the past 12 or so years, dividend yield strategies have outperformed the broader share market by a comfortable margin.

There is a strong correlation between the change in the number of retirees and the performance of dividend yield strategies. The yellow line in the chart below shows the percentage change in retirees (with the green line representing the forecast change) and the outperformance of dividend yield strategies (blue line).  As the number of retirees has increased, dividend yield strategies have outperformed.

Sustained demand for high-yielding equities for at least the next two to three decades as the percentage change in the number of retirees continues to increase, suggests that dividend yield strategies will continue to outperform for quite some time yet.

An active, value-driven approach can help to navigate through the volatility

We would however caution against simply investing directly in a handful of well known high-yielding stocks and locking them in the bottom drawer. This is not an ideal way to invest, due to the risk that pockets of yield stocks may become more vulnerable to shocks as their valuations become stretched.

This risk is exacerbated by SMSFs, which tend to hold stocks directly in a relatively passive ‘buy and hold’ manner as well as invest in index funds and Exchange Traded Funds (ETFs).

To minimise the potential of a portfolio of yield stocks being prone to such vulnerabilities requires active analysis and continual valuation of stocks.  Well-resourced active managers, such as Nikko AM Australia, who have yield strategies but with a focus on value, is one way for investors to help navigate through this potential volatile and uncertain period. It may come as a surprise to many investors but a large portion of outperformance in our high-yield strategies has actually been derived from ‘other’ non-traditional high-yielding areas where opportunities have arisen in specific stocks, rather than the traditional high-yielding stocks.

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Disclaimer: This material was prepared and issued by Nikko AM Limited ABN 99 003 376 252, AFSL 237563 (Nikko AM Australia). Nikko AM Australia is part of the Nikko AM Group. The information contained in this material is of a general nature only and does not constitute personal advice, nor does it constitute an offer of any financial product. It is for the use of researchers, licensed financial advisers and their authorised representatives, and does not take into account the objectives, financial situation or needs of any individual. The information in this material has been prepared from what is considered to be reliable information, but the accuracy and integrity of the information is not guaranteed. Figures, charts, opinions and other data, including statistics, in this material are current as at the date of publication, unless stated otherwise. The graphs, figures, etc., contained in this material include either past or backdated data, and make no promise of future investment returns, etc. Past performance is not an indicator of future performance. Any references to particular securities or sectors are for illustrative purposes only and are as at the date of publication of this material. This is not a recommendation in relation to any named securities or sectors and no warranty or guarantee is provided.

The post When it comes to yield beware of ‘buy and hold’ strategies appeared first on AdviserVoice.

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.

The first two articles looked at the value investing and low beta portfolios anomaly. This article focuses on the third anomaly – the outperformance of concentrated portfolios.

Diversification or “diworsification”[1] : The case for concentrated portfolios

A third source of outperformance for equity portfolios is concentrated portfolios.  Studies have shown that concentrated portfolios are more likely to outperform their more diversified counterparts.

One such study, conducted in 2006 by Jeffrey A Busse, T Clifton Green and  Klass Baks at the Emory University concluded that “focused (ie concentrated) managers outperform their more broadly diversified counterparts by approximately 30 basis points per month, or roughly 4% annualised”.[2]

Another group of academics (Randolph B. Cohen, Christopher Polk and Bernhard Silli)[3] have found that institutional managers do have some identifiable skill in picking stocks. The researchers evaluated the performance of institutional investors ‘best ideas’, which they defined as being those stocks with the highest active positions.

Chart 1 sourced from Cohen, Polk and Silli’s Best Ideas paper, shows the alpha generated by managers’ best idea, second best idea, down to their tenth best idea. What is evident is that the manager’s largest active positions do in fact add significant value.

This is an interesting finding given the widespread belief, backed to some degree by academic research, that institutional active managers as a group do not add value, especially after fees. Given the research from Cohen, Polk and Silli indicates managers actually can identify stocks which will outperform, why then, as a group are they not capable of adding value to investors’ portfolios?

The question is seemingly answered by another interesting finding from the research. Diversification within individual portfolios increased materially over the past 30-odd years. Chart 2 shows the growth in the average number of companies held in US mutual funds doubled between 1984 and 2007.

Chart 2 suggests that while institutions are capable of finding good investments, they dilute the benefit through excessive diversification.

The obvious question that follows is why does this occur? Cohen, Polk and Silli offer a number of potential explanations:

1.     Regulatory/legal. Do legal standards such as the ‘prudent man’ lead to over-diversification in the name of regulatory risk aversion?

2.     Price impact, liquidity and asset gathering. Many institutional managers are paid as a percentage of funds under management. Consequently they have a financial incentive to maximise funds under management. With liquidity limitations and price impact increasing with the weight of money applied, institutions that exhaust the capacity of their alpha- generating ideas may be tempted to continue collecting funds under management and applying it to less attractive opportunities.

3.     Career risk. Underperforming managers face the risk of losing their jobs. Consequently, simply for self-preservation reasons, fund managers may choose not to deviate materially from the benchmark. It has been noted that it is only those managers that materially underperform their benchmarks that tend to be dismissed by clients. Mediocre managers tend to be retained.

Armed with this knowledge, what should advisers and institutional investors do?

There are a number of options that could be considered:

• Look for managers with performance fees. This will limit the incentive for asset gathering.
• Take a longer-term view of performance. This will empower your fund managers to take appropriate risks without the fear of being replaced should there be a period of short- term under performance.
• Accept that you need to do something different. For an outcome to be different to everyone else (ie the market), you need to do something different.
• Look for unconstrained portfolios or benchmark unaware funds. Managers of benchmark unaware funds will be less constrained by the need to deliver performance close to the benchmark over short time frames. As a consequence, these managers can focus on their best ideas without a need to dilute the potential returns through diversification.
• Consider concentrated managers. Concentrated portfolios eliminate or reduce a manager’s ability to ‘di-worsify’. A portfolio with limited names provides reduced opportunities for a fund manager to introduce portfolio fillers. Managers can be tempted to use portfolio fillers to reduce tracking error and thereby reduce relative performance risk. The problem with such action, as was pointed out above, is that by reducing relative performance risk, managers also reduce absolute performance potential and dilute their ability to add value through stock selection.

How can investors tap into these three sources of outperformance?

It is possible to tap into these the potential sources of outperformance, value, lower beta and concentrated portfolios, in the one fund.

The Tyndall Australian Share Concentrated strategy, launched in 2003, is a high conviction, concentrated Australian share portfolio comprising the best stock ideas identified through Tyndall’s proprietary research. The strategy invests in 15-25 stocks in the S&P/ASX 200 Index and is managed using Tyndall’s highly regarded and proven Intrinsic Value process.

The strategy’s performance objective is to provide long-term capital growth and income. To achieve this, the strategy seeks to invest in stocks that have a high total return but also a decent sustainable dividend yield.

The strategy has historically had a lower beta than the market (typically in a range of 0.75-0.90).

As illustrated in part 1 of this series, value investing has outperformed growth investing over the long term.  We are pleased to report that the Tyndall Australian Share Concentrated strategy has outperformed the Citigroup Value Index over the past 10 years as highlighted in chart 3.

A unit trust, which is managed using the same underlying strategy, was launched to the retail market in May 2010 and it ranked in the top 10 Australian share funds in the Mercer Survey in both 2012 and 2013.

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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.

The post Making the most of equity market anomalies – Part 3 appeared first on AdviserVoice.

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.

The first article looked at the value investing anomaly. This article focuses on lower beta portfolios.

Lower beta portfolios outperform higher beta portfolios

There have been numerous empirical studies showing that lower volatility portfolios, and in particular, lower beta portfolios, outperform higher beta portfolios.  This phenomenon is widespread and applies to most equity markets, including the US and Australia.

Clearly, this is contrary to the Efficient Market Hypothesis and the well-known investment axiom of “the higher the risk, the higher the return”.

Certainly, as shown above, as value portfolios tend to have a lower beta and have outperformed in the long run, value is one potential subset of lower beta portfolios.

A quote from Eugene F. Fama and Kenneth R. French (American economist and Nobel laureate in Economics, and Professor of Finance respectively, known for their work on portfolio theory and asset pricing, both theoretical and empirical) from one of their papers in the Journal of Economic Perspectives which was published in August 2004 provides a succinct summary of our view.

“…funds that concentrate on low beta stocks, small stocks, or value stocks will tend to produce positive abnormal returns… even when the fund managers have no special talent for picking winners.”[1]

MSCI produces minimum volatility returns based on the MSCI index constituents, which is a proxy for low beta portfolios.  It is constructed using the Barra risk model and is subject to holding constraints by stock and sector.

As table 1 shows, the MSCI Minimum Volatility Index has outperformed the MSCI broader market index by 0.38% pa – despite targeting lower beta (or lower risk) portfolios by construction.

For completeness, comparable numbers were produced for global equities using the MSCI World Index.  As can be seen in table 2, the numbers show an even more compelling story than Australia, with the MSCI Minimum Volatility Index outperforming the MSCI by 1.52% pa.

The reason why the numbers are more pronounced for the global market may be explained by the greater number of stocks to choose from while still constructing the portfolio within the portfolio constraints.

To test how meaningful these results are, t-statistics have also been calculated in table 3. The t-statistics are not as convincing as they were for value, but they are still on the right side of the ledger.  What they do imply is that a longer time frame is required for the outperformance to come through than the time frame required for value.

Why does low beta investing work?

There are various theories as to why lower beta (or lower risk) stocks tend to outperform higher beta stocks.  The theory that makes the most sense to us is the ‘lottery effect’ of high beta stocks.  This is where investors focus only on the upside or ‘blue sky’ scenarios and bid up the price of a stock on the hope that it could be a ‘ten bagger’ (ie worth 10 times its original amount) without fully incorporating the impact of the potential downside.  This also leads to some investors disregarding the steady, boring stocks as they chase the ‘sexy’ stocks that could make them rich – but in most cases never do… just like the lottery.  We have seen this occur many times in the past.

Another theory is that the lower beta stocks are on average inherently boring and conservative and have good stable cash flows.  As such, they tend to be higher dividend-paying stocks. These dividends are actually cash returns that help to underpin portfolio returns.

Table 4 provides a list of the top 10 lowest beta stocks and top 10 highest beta stocks in the ASX 50 Index as at January 2014.  The names in each list should not be a surprise – reflecting largely the nature of the industries the stocks are in.

One more theory that has emerged recently as to why low beta stocks outperform is the impact of ‘index aware’ investing, and portfolio manager bonuses rewarding more ‘risky’ behaviour in their stock selection – as they don’t get negative bonuses.  It is by virtue of managing portfolios against an index weight, portfolio managers may be compelled to hold higher beta stocks whether they like it or not, and as such, leads to inefficient pricing.  In conjunction with this, the ‘lottery effect’ discussed above comes into play, as some portfolio managers look to achieve big short-term outperformance by taking active positions in higher beta stocks, so as to receive big bonuses.

Chart 1, sourced from Nardin L Baker and Robert A Haugen (in their paper Low Risk Stocks Outperform within All Observable Markets of the World, 2012), depicts this notion graphically, albeit utilising volatility as the risk measure. The ideas are comparable. Given equity markets are considered to rise over time, a manager paid a bonus for outperformance may skew the portfolio to those stocks expected to rise more than the market – ie higher beta stocks.

Other potential explanations outlined by Baker and Haugen in their paper include lower volatility stocks are harder sell to a portfolio manager or investment committee. This is a function of the tendency for low beta and low volatility stocks to have a boring narrative relative to higher beta/higher volatility names and is suggested to have an impact on institution stock selection.

Baker and Haugen conducted research on the largest 1,000 stocks in the US between 2000 and 2009. They categorised these into ten deciles by market capitalisation, from the smallest (on the left in chart 2) to the largest (on the far right). The blue bar shows the stocks that institutions own more of, and the red bar shows the stocks that institutions own less of, within each capitalisation decile. Their research showed that institutions tended to own more of the higher volatility stocks – regardless of market capitalisation. The very smallest stocks were the only exception, where it was lineball.

The more volatile stocks also tend to have greater intensity of broking analyst coverage and greater news coverage.

However, while low beta investing does work in the long run, there are times when it can be in the wilderness for some time, as noted by the lower t-statistics.  These are typically when the market is in the latter stages of a massive bull run or when the market is driven by speculative fads which typically mean the boring, but reliable, low beta stocks can be overlooked by investors for some time.

Intuitively, why will value and low beta continue to outperform?

If value as well as lower beta has consistently outperformed in the past and has done so for less risk, 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 well known and documented for many years.  In fact, these so-called anomalies are really a permanent feature of the share markets.

The real answer for why value investing and lower beta investing has outperformed and why it should continue to do so, may be answered by delving into behavioural finance ie the psychological decision making of investors.

Time and time again, history has repeated itself with the various booms and busts of share markets, and speculative bubbles within the share market itself as investors chase the latest fads and ‘fashionable’ stocks.  In each case, the markets have corrected themselves.  There are numerous examples of varying degrees that have occurred in individual stocks, individual sectors, in whole countries and regions.  They have occurred in so called ‘growth’ stocks which become ‘high beta’ stocks as they rise quickly relative to the market in a short period of time.

We can even go back to the 18^th Century for such examples as the ‘South Sea Company bubble’ in London.  It would seem that investors never learn from history.

In the United States, in the early 1970s there were the ‘Nifty Fifty’ stocks that were the favoured large stocks that raced up to excessive prices, while many of the other stocks were at bargain prices.  In Australia, there was the Poseidon boom in 1970, the speculative bubble in casino stocks in 1996, and short periods of heightened speculation in certain types of low- quality commodity-related stocks since 2003 and up to late 2010.

We only need to recall the Telecommunications/Media/Technology (TMT) boom of 2000 and its subsequent bust for a very dramatic example of when so-called growth and/or high beta stocks moved to stratospheric price levels, while solid companies with real cash flows were sold down heavily as investors chased the latest hot stock.

In each and every case, a great opportunity was created for those investors who stayed with value and did not get caught up in the hype. These opportunities will present themselves again well into the future due to the psychology of investors as inevitably, history will repeat itself again and again.

The next and final instalment from this three-part series will explore the anomaly of the outperformance of concentrated portfolios over their more diversified counterparts.

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[1] Source: Journal of Economic Perspectives – Volume 18, Number 3 – Summer 2004

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.

The post Making the most of equity market anomalies – Part 2 appeared first on AdviserVoice.

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.

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Tyndall AM launched the fund in May this year to the retail market, although the strategy underpinning it has a 15-year track record and was originally developed by Tyndall for institutional investor mandates.   It is managed by Tyndall AM portfolio managers Jason Kim and Tim Johnston.

In its report, Zenith said “[It] believes the Tyndall Australian Equities team is well resourced and highly experienced.

“Tyndall’s team structure and work process is both well organised and clearly defined, with stock and sector responsibilities allocated across analysts (approximately 15 to 20 stocks per analyst) to ensure solid peer review of companies and a ready basis for comparison with other stocks in other sectors.

“The Tyndall team is well incentivised through equity participation and for the most part have worked together for many years. The peer review process ensures that a collegiate environment is fostered and is one of the core strengths of the Tyndall process.”

Zenith added that: “Overall, we consider Nikko AM’s global network to be an advantage for Tyndall in which to gain additional regional and global insights to complement their existing capabilities.”

Matt Russell, head of marketing and sales at Tyndall AM, said the strong rating from Zenith is a positive endorsement of the skills and track record of the Tyndall equities team, in particular Mr Kim and Mr Johnston.

“We are already seeing a high level of interest in the fund after just a couple of months in the retail market, and this is testament to the quality of the team behind the fund and the long-standing success of their investment approach and strategy,” Mr Russell said.

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The fund’s aim is to provide long-term capital growth and income by investing in a concentrated selection of shares listed on the S&P/ASX 200 Accumulation Index.

As at 30 June 2013, the fund returned 29.5% over the previous 12 months (before fees), outperforming the index by 6.2%. Since inception in May 2010 it has returned 11.2% p.a. (before fees) versus 8.3% p.a for the index**.

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