Wow. Could value investing have had a more dramatic reversal of fortune? It was in mid-November 1999 that an earlier version of the chart over yonder first graced these pages. In other words, only about three months in advance (but only half-way there, in percentage terms) of the point of maximum pain for true believers in the value style of investing occasioned by the late, great tech bubble.
Prominent among that then-dwindling band of tech adherents you could (then and now) count the estimable Philadelphia-based money management firm of Aronson + Partners, whose handiwork the chart is.
Positive Territory
Back then, as Kevin Johnson, Aronson's research director, cheerfully admitted that what he called-with thanks to financial writer Jason Zweig, who coined the term-his "Baloney.com" chart was terrifically self-serving, implying, as it did, that sooner or later value would out. Yet value most decidedly has burst back into positive territory, going almost perpendicular in climbing out of that ravine the raging new era bulls had dug on the Aronson chart. [Because the folks at Aronson are (shudder) quants they describe the exercise that produced the logarithmic chart are "simple."
But what it actually illustrates is the return on a paper portfolio constructed by going long the cheapest decile, and shorting the richest decile, based on trailing 12-month earnings, going back practically to the dark ages-on a quarterly basis, between March 1962 and March1980, and monthly since then.]
Indeed, the rebound has created the most dramatic and virtually straight up move on the entire 40-year chart. Fittingly, perhaps, after the steepest plunge, 53 percent, over the 21 months between May '98 and February '00, the value portfolio has roared back up an incredible 239 percent since the dot.com frenzy died in early March, 2000. Which frankly is cause for at least a little concern. And clearly why all you have to do these days is scratch any random value investor on the Street to hear laments about how hard they have to work to find stocks worth buying.
So I called Philly to see if Kevin Johnson and the rest of the Aronson crew share my misgivings. Yes-and no-came Kevin's answer. "Yes, the rebound has been very crazy. But by our lights, it's only sort of back on what we consider to be trend." In other words, Kevin reiterated, even with all the obligatory caveats about how the little paper exercise
represented by the chart doesn't involve transaction costs and all that nonsense, "we really do think the value portfolio strategy works."
Besides, he added, "there's nothing that says that it can't overshoot. Just imagine, having seen how much it undershot, imagine it were to overshoot that much on the opposite side. In other words, if you think value's performance is anywhere near back on its long-term uptrend line, imagine if it bounced-depending on how large you print the chart-call it another inch and a half over the that trend line. That would take it up another whole bunch of percent."
In that event, no doubt, value investors would think they'd died and gone to heaven-and they'd inevitably be about to get killed, given the market's cyclical tendencies. And Kevin is grounded enough to hope the market doesn't get as carried away on value as it did on the dot.bombs. "Too much volatility is just not a good thing. We think we're reasonably bright boys and girls-we sure didn't like looking stupider than we were, way back when baloney.com held sway. But it's also a little odd looking smarter than we really are right now, in truth."
Poor Timing
When I jumped on him to point out that volatility is what creates opportunity in markets, Kevin explained that what he was really referring to by "volatility" was investors' changing preference for value versus anti-value. "I mean, you can imagine the clients who bailed at the wrong time. The thing is, if this were real estate and it didn't price everyday or in the case of this chart, every month, then nobody would know any difference. The long-term trend would just be climbing up, and who the heck would know? You'd end up where you were supposed to be, just as if you had been Rip Van Winkle in the interim.
But it does price everyday- and people act on those prices. Some people got out at the bottom. Some managers changed their stripes. So just getting the long-term return line back to do where it is supposed to be isn't the same for everyone as it would have been if we had gotten here in a straight line, the way we'd have liked to have."
Quant Power
But the real hang-up Kevin has with volatility is that it only generates big opportunities "when you can time it." Which is something that Kevin and his colleagues, despite all their quantitative fire power, continue to insist can't be done in way that's worth the extra risk. "You'll recall that the last time we spoke about this, the value strategy was still in negative territory-and we were being as adamant as we could be with our clients, and indeed with anybody who would listen, telling them that it would end. But back then, their natural reaction-because they were losing money each and every day-would be to say, "When?" And our only answer was, "I don't know." If we knew, we would have baked it into our investment process, because then we could have made all the money in the world. But we tell people we don't even bet sectors. We don't bet technology versus utilities, because we don't know how. You need to know your limitations."
Teased a little, Kevin holds his ground, "Sure, you can make some rough estimates, which is what a lot of people do, looking at things like P/E spreads between the rich and cheap deciles of the market, that sort of thing. But if you run that, for example, on the stocks in this little return exercise, what you find is that, 49 out of 100 times, when spreads are wide, they get wider. Yes, they're supposed to get narrower-and they
do if you're willing to wait-but many times, when they're wide, they get wider and when they're narrow, they get narrower. Which defeats any sort of timing scheme. So yes, things revert to the mean-just not when you want them to. I don't know what your philosophy of life is, whether things are supposed to land jelly-side-up or -down. But the fact of the matter is, they just seem to land jelly-side-down way too often."
Can't argue with Kevin there. Murphy rules. If he didn't, wouldn't all of our grandparents have made such brilliant investments that none of us would have to bother working? And in fact, says Kevin, that's sort of why he and his co-workers think the buy value, short the rich stuff strategy they charted produces positive long-term returns. "It's probably only the very painful periods-like we saw at the end of the 20th Century- that allow our chart line to slope up at all. In other words, it's incredibly painful at certain times to hold value stocks-if it were easy, everybody would do it. The fact of the matter is, when you were holding throughout late '98, all through '99 and into the very beginning of 2000, it was excruciating. The number of people who told me, "It ain't ever coming back." And, "forget about it." And, "What are you doing?" And, "You're missing it." And "This time it's different…"
Gee, somehow he forgot, "You just don't get it," probably the most brutal thing to say to somebody, when their portfolio is underwater. And it was the mantra of the new agers. But now, quite evidently, the tables are turned. Kevin notes that the Russell 2000 Growth index, annualized, for two years through March, is down 22.9 percent, while the Russell 2000 Value is up 22.2 percent.
Yet as good as that's been for the Aronson folks and their clients, Kevin recognizes it's also out-of-whack. "All of the folks who ran running and screaming from all their small-cap value portfolios and over to the other side in 1998 and 1999 and early 2000, I think are screaming and running back now-and on top of their losses, they are paying some serious dough to trade. If they're not paying it directly, their mutual funds or underlying investment managers are."
The temptation, for a cynic like this writer, is to question whether the folks now flocking (back) into small-cap value aren't doing it at precisely the wrong time. For their part, the Aronson team is sticking with its quantitatively-defined investment styles. "Sure," says Kevin, "there are some levers in our process that we could use to change things around-we could presumably adjust some dials to, in effect, like value less-if we saw things running away on the opposite side. But now let me make the mirror image case to you-and you tell me whether you'd be willing to step up to the mike on it. Imagine we're back in January of 2000, and you think relationships are out of whack, that is, spreads are huge between, say, earnings yields for the cheap stocks versus the expensive ones or say you see that our return chart is showing unprecedented deviations from where you think it should be over the long run.
Mirror Image
"At exactly that point, the mirror image investment strategy would be to double down. You'd say, God, I really want to turn value up because this is really going to pay off.' The thing is, I know a lot of people who instead bailed out at that point. I also know a few people who stayed the course. But I don't know anyone who doubled down. It's really extremely tough to play this game and make money. Because remember, to move from Point A to Point B, you've got to trade. And it's quite possible to incur the dead-weight loss of trading and then have to wait months, quarters, maybe years, to get paid. That's real tough."
Instead, Kevin avers, he on the whole prefers his firm's tack, which is to hang with their value style through thick and thin-and pick up its long haul advantage. "Which, frankly, is back," as their chart makes exceedingly clear.
But the Aronson chart also clearly has implications for the richly priced cohort of the market. The ones their little exercise shorts. Those stocks, by and large, are still the big-cap, sky-high P/E types that populate the name brand averages. And they still seem quite vulnerable to this jaundiced eye. Kevin is only a mite more reticent: "We generally don't like those names." In part, it's because of past experience. Kevin used to run Vanguard's index fund, "and the funny thing about running an index fund is that you've got to buy a lot of that stuff"-without regard to price or value. But the primary reason the Aronson crew shies away from the name brand big caps is simply their value orientation. "Because how does a stock get to have a big representation in an index? With a high price. Well, all else being equal, what does a high price mean? Too high a price. So we are shy those names. Sometimes we don't own them at all. Sometimes we merely own underweights in them. We lost money on this relative basis on GE for a good long time-and now we've made some for a little while on this same relative basis. But I think all that stuff is overpriced. Then kind of by definition, by composition, the S&P as a whole, is also overpriced, just because of the top-heaviness in it."
Whatever it's called, it's become a favorite way for portfolio managers to, in effect, take cover in the herd in an increasingly volatile market. As Kevin puts it, "all you have to do is decide that even though-in times past-you wouldn't have held any of this GE, but you know what?
Now, you're going to hold 200 basis points. Just because you were a little spooked by having a 400 or 500 basis point underweight in that horrible piece of crap. Oh, I'm sorry. In that icon of American commerce. I suspect that is the kind of movement toward indexing that has supplied some of the juice that has kept the S&P priced at 30 times forward earnings or whatever the hell its multiple is."
Kathryn M. Welling is the editor and publi-sher of welling@weeden, an independent research service of Weeden & Co. L.P., Greenwich, Conn. http://welling.weedenco.com
