Every few years, The Value Perspective undertakes a fund ‘health check’ by reviewing the last decades’ worth of performance numbers for the portfolios we run. What we are hoping to see from the data is not that it exactly mirrors any particular previous time periods but that the pattern of the returns being generated looks very similar.
That is because, if the pattern of returns looks similar today to what it did five years ago and 10 years ago and so on, then that would suggest we are operating a durable, rigorous and repeatable investment process. This does not of course mean it will not suffer difficult patches from time to time – only that, when it does, it ought not to come as a surprise to investors.
Now, since value investing’s success is built on the fact that, while markets and economies may change, it does not, it would be awkward had our latest review revealed any material inconsistencies in the pattern of returns generated but, happily, it did not. What it did offer, though, were some interesting insights into how a ‘deep value’ investment approach performs in rising and falling markets.
To keep things simple, we are going to focus on just one of the portfolios we manage – let’s call it the Behavioural Finance UK Deep Value Improvement Fund™ – and its performance over a decade where, even though equities hardly had a statistically amazing time, the UK market still enjoyed more ‘up’ quarters than ‘down’ ones and ultimately made a positive return.
One of the less surprising parts of our exercise was the confirmation that, in the quarters when markets rise, the fund tends – on average – to perform slightly better versus its benchmark index while, in the quarters the market falls, it tends not to do quite so well. What is perhaps more surprising, however, is the fact that the fund actually does not perform too badly in those negative quarters.
Over the last 40 quarters, there were 14 where the market went down – in other words, about two-thirds of the time you made money on a quarterly basis investing in the UK stockmarket. A good start. Of those 14 quarters where the market did drop, the fund fell further than the market exactly half of those times. Broadly that is quite an encouraging statistic, being less than 20% of all quarters in the last 10 years, however, each of those individual periods would, of course, have been quite painful for investors, no matter how transient it – thankfully – turned out to be.
Clients do not like underperforming a falling market – it can make them very nervous indeed – but, while it will happen, the fact value tends, over time, to be quite a defensive strategy means it does not happen that often. The other way to look at the numbers above is to say that the fund actually outperformed a falling market 50% of the time and, even more encouragingly, the net result of all performance – both positive and negative – achieved during falling markets was ... zero.
Thus, over the last decade, the fund – on average – neither underperformed nor outperformed a falling market. Plenty of investors would assume a deep-value fund to be very pro-cyclical and so you would win on the upside but lose on the downside. Yet, in reality – on the evidence of the last 10 years – it would appear you win on the upside and, broadly speaking, you do not lose on the downside.
None of which is to suggest there will never be a single quarter in any 10-year period where the market falls 10% and the fund drops 20% and it all feels like a disaster – in fact, that is quite a likely scenario. However, in falling markets, on average, the fund has held up encouragingly well, which is deeply ironic when you consider this is a very unconstrained and potentially quite volatile product.
Yet it is precisely those qualities that enable the fund to end up with the return profile it does. Indeed, if we were to tell you we had a product that, on average, has added just under one percentage point of relative outperformance every quarter over the last 10 years and, furthermore, it holds its own in negative quarters while outperforming in positive ones, would you not be eager to hear more?
That, however, is when we would have to say that, every so often, investors are going to see a quarter when our product is well behind the market and, when that happens, it is going to hurt. That is the uncomfortable truth with which any investor in the Behavioural Finance UK Deep Value Improvement Fund™ must come to terms.
Nevertheless, the whole exercise goes to show that, the longer the time periods over which you analyse the performance of value investing, the more you reveal the power of the strategy and the discipline involved in its implementation.