In two recent articles, The Value Perspective has stressed the importance of sticking with your investment process no matter how stupid, mad or just plain wrong other people might accuse you of being. This holds true whether, as an investor, you have been going through some difficult times, as we saw in Short notice, or some good ones, as we ourselves have enjoyed, as referenced in Open-and-shut case.
Without wishing in any way to be seen as showing off, we thought it could be worthwhile to offer an observation on just why one of our portfolios, for the first time ever in its 42-year history, has outperformed its benchmark by more than 20 percentage points for two years in succession.
We have benefited from two things, one of which clearly was that the broader market was cheap. More important than that, however, was the cheapest part of the market was extraordinarily cheap relative to the broader market. Since then, two things have happened. Yes, the broader market has risen – although in our view it is not as crazily valued today as some would have you believe and history suggests reasonable returns can still be made – but that super-cheap part has run right up.
The gap between the super-cheap part of the market and the average valuation is technically known as ‘valuation dispersion’ and this now stands at its lowest level since 2008 – which of course was the last time the market peaked. Unfortunately, this combination of reasonable valuations but low valuation dispersion can muddy the investment waters.
Normally, as value investors, we know the right thing to do – we buy stocks when they appear cheaply valued and sell them when we believe they are expensive. There are times, as we hinted at the start, where doing the right thing might feel distinctly uncomfortable but, nevertheless, we stick to our investment process.
Today, it is less obvious because, with the exception of a few stocks, the cheapest part of the market is not much cheaper than the broader market. As a value investor, you then have to ask yourself whether you really are being paid to take the risk – because those cheaper companies probably are riskier. It is a very interesting question and one currently provoking much debate at The Value Perspective.