In the depths of the Great Depression, US investors may well have felt like a drink but they presumably would have been less inclined to buy into the whole sector. According to a piece of analysis on the Philosophical Economics blog, however, it would have been a great long-term investment as, between 1933 and 2015, US beer and liquor stocks produced a real, inflation-adjusted total return of 10% a year.
This compares with a return of half that from the US steel sector and, over the whole 82-year period, that underperformance boils down to the difference between turning $1,000 into $26m in real terms or a rather less impressive $57,000. Still, as Philosophical Economics is quick to point out, that is all in the past and, looking ahead, the key consideration is what lies behind the difference in performance.
One possibility, the blog goes on, is that beer companies could just be better businesses than steel companies and so enjoy better returns on investment. Alternatively, the difference could be down to changes in valuation, with beer companies perhaps being very cheap back in 1933 and very expensive today while steel companies’ valuations may have headed in the opposite direction.
As a value investor, if you believe the difference is down to return on investment, then – assuming they are trading on similar valuations – you would want to be overweight the beer companies. If you think it is down to valuation, however, then – because, over time, asset returns tend to revert to the mean – you would want to do the opposite, all else being equal, and now favour the steel companies.
The trick, as Philosophical Economics observes, is to be able to distinguish between underperformance that is driven by a structural lack of profitability in the underlying business or industry and underperformance that is driven by negative sentiment and the low valuation that naturally follows. “The latter is likely to be followed by a reversion to the mean,” adds the blog. “The former is not.”
The piece then sets out to chart the fundamental equity performance of 30 US sectors, from 1933 to 2015, in “an effort to ascertain the extent to which differences in the historical performances of different industries have been driven by factors that are structural to the industries themselves, rather than cyclical coincidences associated with the choice of starting and ending dates”.
Anyone interested in precisely how the fundamental equity performance data was arrived at should visit the Philosophical Economics blog, where the methodology is laid out in some detail. In essence though, it focuses on the only two variables available back to 1933 – price and dividend – adding: “They are all that are needed to do the analysis. Dividends are the original, true equity fundamental.”
And what the analysis ultimately shows is that, over the last 82 years, beer and tobacco companies have been consistently superior businesses with structurally higher returns on investment whereas sectors such as steel and mining have been more inclined towards a cycle of boom and bust. They do enjoy some periods of strong growth but generally only as they are emerging from a previous crash.
That, however – and, as we said, the blog acknowledges – is all in the past and, while certainly very interesting, does not tell us which industries will perform well from now on. Neither beer nor steel businesses, it adds, are necessarily “going to exhibit the same fundamental performances over the next century – conditions can change in relevant ways.
“And if we believe that the businesses are going to generate the same fundamental performances that they generated in the past, it doesn’t necessarily follow that we should overweight or underweight them. The relative weighting that we assign them should depend on the extent to which their valuations already reflect the expected performance divergence.”
In other words, no matter the industry, ultimately it does all still come down to the price you pay for an investment. That will come as little surprise to regular visitors to The Value Perspective, who will be well used to seeing articles along the lines of All in the price, so we will instead conclude this piece in a slightly different way.
The Philosophical Economics blog naturally talks a lot about distinguishing between businesses that are cheap for cyclical reasons and those that are cheap for structural reasons – the so-called ‘value traps’. What we would add is that it is through the market’s eagerness to avoid the latter – and the consequent overshooting in valuations – that the consequent opportunities for value investors appear.