Over the years, the stock market has rewarded the simplest of investment strategies: buying the downtrodden. The founder of modern security analysis, Ben Graham, did not usually directly seek stocks that had declined in price, but his advice to buy that which cost little had much the same effect.
In the mid-1980s, two academics considered the improbable: Could investors succeed by adopting the brain-numbingly simple tactic of screening for the stock market’s biggest losers, forming portfolios based solely on that information, and then holding for the next three or five years? Yes, concluded Werner De Bondt and Richard Thaler in “Does the Stock Market Overreact?,” they could. Earning excess returns really was that easy.
All right, you may be saying, all this history is fine and good, but show me the money. That I cannot do, not recently. For example, DFA US Large Cap Value, founded by those with an academic bent who wished to put theory into practice, has lagged the S&P 500 over the past decade. It isn’t behind by much—82 basis points per year—but trailing is trailing. The company’s DFA US Small Cap Value fund is another half-percentage point behind. Since the early 2000s, when cheaper stocks far surpassed expensive growth companies during the 2000-02 sell-off, value investing hasn’t been a benefit.
Nobody knows why, because value stocks—as with the overall stock market—aren’t forthcoming when interviewed. (Every headline that purports to explain why stocks rose or fell the previous day is speculation.)
Reasonable guesses are: 1) Coming off a great period of relative performance, value stocks were due to subside; 2) The story of value stocks’ superiority has been so thoroughly told that it no longer is something of a secret; or 3) Other companies have increased their profits more than expected. To expand on that third item, growth stocks carry higher profit expectations than do value stocks—that is why they are called “growth,” and why they command higher price multiples—but in recent years, they have followed through on that promise.
I suspect that all three are true, to varying extents. I also suspect that the historical “premium” that has been available for value-stock owners has diminished but is not extinct. After all, the penalties associated with bargain-priced stocks remain intact. They are not enjoyable to own. Their companies are often hounded by bad news, and in the most extreme cases, their businesses are so wretched that they go bankrupt. No portfolio manager wishes to explain why he or she was so foolish as to retain a stock that was delisted.
From Stocks to Funds
But—to arrive at the point of this column—stocks are not funds. Should my reasoning prove correct, and the value/contrarian style stage a comeback, that still does not help the mutual fund (or exchange-traded fund) buyer who wishes to apply the precept of “buy that which has declined the furthest.” That is because funds are not static. Portfolio managers typically do not retain the stocks that have sustained the worst losses; for better or worse, they act. They decide, in many cases, that those securities must be pruned, and the proceeds reinvested into better opportunities.
Thus, when sifting through lists of mutual fund performers, the logic is not as clean as with stocks. There’s more to the argument than, “These securities have been the most disliked by investors, and because we know via behavioral research that people often overreact to problems, they may have become too cheap.” With funds, there is the additional wrinkle—the possibility that the fund’s portfolio manager(s) may have erred. Attempting to profit from the mistakes of the masses is one thing; embracing one individual’s (or management team’s) personal errors is quite another.
I learned that the hard way. Twenty-five years ago, as the academic papers demonstrated the power of contrarian investing, Morningstar’s research team began to wonder if similar insights could help mutual fund investors. Would purchasing the fund industry’s biggest losers make sense? We tortured the data this way, then that way. Try as we might, however, we couldn’t find any useful pattern. Yes, sometimes beaten-down funds would rebound sharply over the next few years. But just as often, if not more, they would remain terrible.
Therefore, regardless of whether stocks regain their value mojo, so that equity portfolio managers with a contrarian bent may once again outperform the broad-market indexes (if not necessarily value-style indexes), I cannot recommend badness as being a virtue for funds.
Fund investors can be contrarian by understanding which categories of funds have been most redeemed by their shareholders, as described in Morningstar Analyst Russel Kinnel’s annual “Buy the Unloved” series. Unlike with stocks, where selling pressure depresses share prices, fund redemptions don’t knock down net asset values. Thus, funds, unlike stocks, don’t become potential “bargains” because they are disliked. However, their shareholders’ actions may nonetheless tell something about the type of securities that a fund holds. That market sector might be deeply unpopular, and thus due for a rebound.
In short, the contrarian approach may help for selecting stocks, but not for funds. With funds, to the extent that contrarianism is helpful, its insights apply to asset classes.