Regular visitors to The Value Perspective will be aware how keen we are that investors aim to commit to a value strategy for the longer term – three years at the very least and preferably more than five. This is because there will be years when value does very well as a strategy and years when it does not. As it happens, the 12 months to the end of May falls very much into the former category.
We do not point this out to brag – well, maybe a little as, after all, value as a strategy is up by more than double the 30% rise of the broader UK market over the period – so much as to highlight some illuminating and recurring patterns that can be found within this outperformance.
One way of evaluating a fund manager’s skill is to see if their investment decisions have contributed positively or negatively towards performance by comparing them to a benchmark index. If you were to carry out this ‘attribution analysis’ on the individual stocks of a typical value portfolio over the last 12 months, you would in all probability find a handful of standout performers followed by a longer ‘tail’ of less meaningful though still positive contributors and a similar pattern on the negative side as well.
The point about value investing, however, is it is, at its base, playing the averages over time. So in any analysis such as the one above, you would expect to see average patterns and you would expect to find the handful of star companies contributing significantly more to performance than the handful of bad performers took away. Similarly the tail of still meaningfully positive performers will add more than the tail of stocks that have performed negatively will lose.
In that context, over the last 12 months the outperformance of just one stock in a value portfolio, such as Dixons Retail, could well have more than offset the total negative contribution from the poorest 10 or 15 companies.
At first glance, this suggests outperformance is driven by stock-specific selections – and of course, at an individual stock level that is where a lot of a fund manager’s ‘value-add’ does come from – however, the real outperformance stems from the statistical outperformance of lowly valued companies over time. It is a mechanical thing – by continuing to fish for ideas among the cheapest companies you are more likely to invest in ideas that outperform.
So, yes, the last year has been a great time to be a value investor but the patterns of performance and contribution have been consistent with the sort of pattern you would expect to see over the longer term of three to five years – that is, bigger outperformers contributing a bit more than the bigger underperformers lose and the positive tail just doing a little better than the negative one. It looks random but, over time, these small differences add up to create the value premium – the statistical outperformance of lowly rated stocks over their peers.
These small differences also compound over time and can add up to a really quite significant one so that, while no one stock selection may stand out, cumulatively and over time, you find you have doubled the return of the broader market. It is a very powerful effect.