Stranger Things
The smash-hit Netflix series, Stranger Things, chronicles mysterious events that emerge from an “Upside Down” version of our world. Perhaps the stock market’s behavior over the past ten years will be featured in the show’s next season?
Think back to the summer of 2010. The global economy was emerging from a crisis that was triggered by overpriced real estate. Imagine you had received a call at that time from a fund manager, pitching a new investment strategy. “Never mind the fact that speculative purchases of expensive assets caused the last market crash,” explains the caller. “We have a great new strategy for the next decade: buy the most expensive stocks with the lowest profitability.”
How would this speculative strategy have performed over the next ten years? Turns out, this approach of buying expensive, unprofitable companies would have tripled an investor’s money over the subsequent decade, with a $100 investment in July 2010 growing to $321 in June 2020.
Meanwhile, a rational strategy of buying highly profitable companies at cheap valuations would have been left behind, with the same $100 investment in July 2010 being worth $167 in June 2020, as illustrated in the chart below.
Figure 1: Growth of $100 in Global Developed Markets (2010–2020)
Source: Ken French data library (June 2020).
But what if the fateful call in 2010 had come two decades earlier? Would expensive, unprofitable companies have outpaced cheap, profitable firms over a longer horizon?
In 1992, Nobel Prize-winner Gene Fama and his colleague Ken French published their famous “Three Factor Model,” which demonstrated that value is an important factor that explains equity returns. Although investors have known about value since at least the days of Ben Graham, 1992 was the first time this factor was popularized in quantitative investment models.
So we looked at the performance of value since 1993, in combination with profitability. The table below shows the annualized returns of global stock portfolios that were sorted according to firms’ valuation characteristics (cheap to expensive) and their profitability characteristics (low to high). Returns of the cheapest, most profitable companies are shown in the bottom left cell. And returns of the most expensive, least profitable firms are shown in the top right cell.
Over the past three decades, companies that exhibit both cheap valuations and high profitability have delivered the highest annualized returns in the market, compounding at 12% per year.
On the other hand, the most expensive, least profitable companies have delivered a paltry 2% annualized return over the past three decades.
Figure 2: Annualized Returns in Global Developed Markets (1993–2020)
Source: Ken French data library (June 2020).
If an investor had followed the speculative approach and held expensive, unprofitable companies since 1993, then a $100 investment would have been worth $184 in June 2020, after a long 27-year wait.
Conversely, if the same $100 were invested in a strategy that holds the cheapest, most profitable companies since 1993, that investment would be worth $2,116 in June 2020!
How should investors today weigh the historical evidence? Over the past decade, the speculative approach of holding expensive, unprofitable companies has created 3x more wealth than the rational strategy of buying cheap, profitable firms. Yet the opposite is true over a longer horizon. Over the past three decades, the rational strategy has generated over 11x more wealth than the speculative approach.
The 18th-century statistician and Presbyterian minister, Thomas Bayes, also grappled with the question of how to evaluate conflicting evidence. The answer he proposed—now formalized as Bayes Theorem—is to start with a prior belief (e.g., “cheap, profitable stocks are likely to outperform expensive, unprofitable stocks”) then update that belief based on the strength of new evidence. For example, if the stock market’s strange behavior over the past ten years leads one to question the efficacy of buying profitable companies at low valuations, then those doubts should be laid to rest by the counterevidence from the past three decades. In fact, the three decades of evidence in favor of value investing carries much more weight because of its longer horizon. Therefore, investors should be more convinced about the efficacy of value investing after evaluating the longer horizon of evidence.
Indeed, when we extend the time horizon as far back as reliable records allow, we find even stronger evidence in favor of buying profitable companies at low valuations. The United States has reliable financial statement data for public companies starting in 1963. Over the six decades between 1963 and 2020, stocks that are cheap and profitable have compounded at 13% per year. And over the same period, expensive and unprofitable stocks have lagged far behind, compounding at only 4% per year. The difference in wealth creation between these two approaches over a six-decade horizon is staggering: $100 invested in 1963 would be worth $131,130 under the rational strategy and $993 under the speculative approach.
Figure 3: Long-Horizon Outcomes in the United States (1963–2020)
Source: Ken French data library (June 2020).
Over the past six decades, the rational strategy has created 132x more wealth than the speculative approach. So following Bayes Theorem, our prior belief that “cheap, profitable stocks are likely to outperform expensive, unprofitable stocks” should be significantly bolstered after seeing six decades of supporting evidence.
Under this Bayesian framework, we can better evaluate the unusual outcome of the most recent ten years. Compared against six decades of evidence in favor of buying profitable companies at low valuations, the unlucky experience of the past ten years should not even make a dent in our conviction that value investing works over the long run.
Ultimately, the rational investment logic of “buy low, sell high” is well supported by six decades of evidence. Whereas, like a game of musical chairs, the speculative logic of “buy high, sell higher” seems fun until the music stops.
The stock market is noisy, and strange things can happen over three, five, even ten years. But over the long haul, investors eventually get what they pay for. Those who buy expensive equities at low yields usually realize low returns over the long run. And investors who buy cheap stocks at high yields can realize high returns—provided they stick with the strategy over the long haul.