“Want to bet on it?”
Nearly everyone has put their money where their mouth is. Win or lose, something simple unites both sides of every bet: each thinks they have a greater than 50% chance of winning.
Clearly, as a species we’re pretty overconfident: half of us must lose every wager.
Investing isn’t betting, but…
Investing, of course, isn’t betting because there is an expectation of positive long term returns.
But because we love to bet, we can’t help but inject a little gambling by trying hard to beat the expected long term average market return. Unlike a friendly wager, speculating in the stock market has transaction costs, and far more than half of us end up losing.
Hope, of course, springs eternal.
But what if there really was a way to increase your odds of beating the market?
In this piece I share two ways of beating the overall stock market, including some terrific charts that illustrate the odds of success for both strategies. In my hour-long investor presentation, these charts are the showstoppers.
There are exactly two ways to beat the overall stock market:
- The Size Effect (small minus big) which states that small companies outperform large companies
- The Value Effect (value minus growth) which states that value companies outperform growth companies
The size effect is smaller, but was discovered earlier and is easier to explain. We’ll tackle it first.
The Size Effect – Small Minus Big
There are roughly 6,400 public, exchange-traded companies in the United States. If you rank them by their market cap, the smallest 25% have outperformed the largest 25% by around 3.6% per year, since 1926.
There are sound reasons for this: small companies are more volatile. There are periods when big companies do better than small, but on average, risk = reward, and small companies outperform.
The Size Effect is Discovered
The Size Effect was discovered at the University of Chicago in the early 1980s. Placing their own bet, David Booth and Rex Sinquefield founded Dimensional Fund Advisors on the promise of this academic research, launching a small cap index fund in 1981 with a board that included Nobel Prize winners Merton Miller (1990) and Myron Scholes (1997) of Black-Scholes Option Theory fame.
Dimensional has since grown to over $200 billion under management, and as a thank you Booth donated $300 million to his alma mater in 2008, which was renamed the University of Chicago Booth School of Business.
Got 5 years? Go small.
In the US, anyone with at least a 5 year investment horizon will find the advantage in small companies compelling. Internationally, the odds improve even further.
The Value Effect is a little more complicated, but it is also more lucrative. I encourage you to give the explanation of book-to-market an extra read. The Value Effect is worth understanding because of how profoundly it affects returns.
The Value Effect – Value Minus Growth
In 1992, Professors Eugene Fama and Kenneth French of the University of Chicago published their now-famous article “The Cross-Section of Expected Stock Returns” in the Journal of Finance.
Fama & French added to the research on Small Minus Big, creating an additional risk factor called the Value Effect, also referred to as Value Minus Growth, or High Minus Low.
Calculating the Size Effect is easy: we just rank every company by market cap and compare the small to the big. To get to the Value Effect, you have to calculate the Book-to-Market ratio of every company, which you do by taking the book value of the company (assets minus liabilities) and dividing it by the market cap.
Let’s consider book-to-market for a minute: the book value is the stuff the company owns, and the market value is what investors are willing to pay for it. Typically, investors are willing to pay more for a company than the value of its stuff because investors are expecting the company to grow.
Value and Growth: Example Companies
In the case of Bank of America and JP Morgan/Chase, investors are clearly skeptical that company assets are even worth what their management says they are. These are DEEP VALUE companies. At the other end of the spectrum, people are paying a lot for what they are getting.
Amazon is worth 10X more to shareholders than the value of its assets. This is a GROWTH company. For Amazon to be worth what people are paying, it must continue to grow. If it fails to grow quickly, investors paying today’s stock price for the company will be disappointed with their investment.
The Value Effect – How It Works
As Fama and French established, Value companies have higher returns than Growth companies. They showed that if you rank all public, exchange-traded companies in the US by their Book-to-Market ratio, you will see that the top 25% (the value companies) outperform the bottom 25% (the growth companies) by 5% per year since 1926.
This outperformance is technically called High Minus Low in the literature because the high book-to-market value companies outperformed the low book-to-market growth companies. To keep things memorable, we can call it Value Minus Growth instead.
Value Rings True.
Like any good piece of academic research, Fama and French’s work rings true: if you pay less for something, then chances are better that you got a good deal.
However, there is a caveat: Value companies are inherently less stable than growth companies. They are riskier. If the economy goes south, they may suffer more. This comes as no surprise: if you want a higher reward for owning a stock, then you must expect that stock to be riskier.
Got 5 years? Go value.
Buying Value vs Growth doesn’t mean getting a free lunch, but it does mean something: if you are willing to bear the risk of owning value companies, than you can earn much more during your time in the stock market.
Most investors are blown away by this data, which suggests pretty clearly that sexy-sounding “Growth” funds are a real turn-off for profit-minded investors.
That was easy.
Investors often see this extraordinary data on the size and value effects and incorrectly conclude that there must be other ways to handicap the stock market.
My weblog makes it look very straightforward, but remember that the size and value effects are the results of 50 years of research into equity performance. These findings seem obvious in retrospect, and anyone can easily replicate them, but they didn’t come easy at the time.
Nothing else predicts returns.
Unfortunately, no other way of chopping up companies produces anything useful.
You can perform advanced statistical computations all year long with dividend yields, price/earnings ratios, projected growth, chart reading, market timing, country picking, bubble identification, analyst consensus estimates, etc. but you will learn nothing about which companies will have better equity performance.
Only market cap and book-to-market mean anything.
Short of illegally obtaining and acting on inside information, there is no other demonstrated way to beat the market beyond tilting your portfolio so that you do not own the whole market, but instead own that fraction of the market that corresponds with your desired tilt towards small and value.
Take a hard look at your portfolio.
As an investor, it is time to take a hard look at your portfolio. If you see “investment ideas” that are founded on someone’s prediction about what sector will outperform, then you need to be aware that there isn’t any evidence produced by any credible source that suggests that any idea other than small or value does anything to increase returns, and even that only approaches 100% over longer investment horizons.
More to life than small-value
Please don’t take from this article that the correct way to structure a portfolio is to buy only small-value equities. While this can work for “very long term” accounts such as IRAs for younger investors, in general you should employ other asset classes including Large-Value and Mid-Value to structure portfolios that will produce even better odds of beating the overall market over shorter time periods, where rebalancing can drive profits.
Small-value tilts mean higher returns with less portfolio risk
The goal of small-value investing is simple: to use science to increase returns for any given level of portfolio risk.
The correct way to use small-value is as follows:
- Incorporate some small-value tilt in your portfolio, both domestically and internationally.
- Recognize that in exchange for more return you will have more risk in your equities.
- Mitigate this risk by owning more bonds, which reduce risk.
Done correctly, you will have higher returns from your equities, with your volatility dampened by a slightly higher proportion of bonds.
Ready for more? Take a look at how Ross Asset can help.