Value Investing: When History May Not Be Enough
Might this time be different?
The Long View
Finance professors are historians. Because their research must withstand tests of statistical significance, it typically is conducted over prolonged time periods. Consequently, they also tend to distrust growth stocks. The broad view informs them that today's champions become tomorrow's also-rans. Competitors arise, while winners grow complacent.
Management consultants have a different perspective, as they are paid to identify ongoing corporate advantages. When Tom Peters and Robert Waterman Jr. penned the 1982 best-seller, In Search of Excellence, it was to highlight "eight basic principles of management" that, in their view, enabled companies to succeed. Unfortunately, the businesses that they profiled were less remarkable after the book was published. For the most part, their financial health declined.
Five years later, a cynic named Michelle Clayman wrote a rebuttal, "In Search of Excellence: The Investor's Viewpoint." Using Peters and Waterman's methodology, Clayman compiled a list of the worst-scoring firms at the time of the book's launch. Over the ensuing five years, she found, the businesses of those "unexcellent companies" consistently improved, even as those of the allegedly excellent companies slipped.
Their stock prices behaved even more dramatically. As fundamental fortunes shifted, the leaders no longer were so alluring, nor the doormats so contemptible. Accordingly, the price multiples that investors paid for the two stock groups converged. That movement gave the unexcellent companies a double boost. Not only did their earnings increase but so did their price/earnings ratios. As a result, the group outgained the S&P 500 by an average of 12 percentage points per year.
Value Investor, Ph.D.
The knowledge of such experiences turns most finance professors into value investors. Money-management firms founded by finance Ph.D.s typically follow value strategies. Dimensional Fund Advisors does, as do AQR Capital Management, LSV Asset Management, and Fuller & Thaler. The organizations diverge in their details but not in their underlying principles: Assume that most investors overreact, and take the other side of the trade.
The drawback to that mindset is that, on rare occasions, the underlying pattern does indeed change. Finance professors are unparalleled at amassing and analyzing investment data, but they do not excel at identifying turning points. In 1990, nothing in the history suggested that U.S. inflation could remain steadily low for three decades. (Not that many economists predicted the event, either, but they at least stood a chance.)
I write this after reading a striking passage in "Public to Private Equity in the United States: A Long-Term Look." Authored by Morgan Stanley's Michael Mauboussin and Dan Callahan, the paper--a wonderful reference for those of you who seek such things--broadly examines the state of the U.S. equity marketplace. Among its topics is the shrinkage of publicly listed companies, which numbered over 7,000 in the mid-1990s but only 3,600 today. (As of year-end 2019, the Wilshire 5000 Index contained but 3,473 members.)
Several reasons underlie this decline, including higher listing fees, greater regulatory requirements, and improved funding from private equity sources, should companies seek capital without going public. But the biggest explanation is fundamental. From a business perspective, as opposed to investor sentiment, large companies are leaving small companies far behind. Write the authors, "The difference between the median return on assets for large and small companies was 15 percentage points in the 1990s and is now in the range of 30-35 points."
Small businesses by nature are less profitable than larger firms, both because they lack scale and because they tend to be younger, which makes them likelier to reinvest in their businesses. But 30 to 35 percentage points is massive! Also worthy of exclamation is that that the change occurred over a single generation, with the difference between small- and large-company margins doubling within 25 years.
The growing disparity owes partially to smaller firms' struggles. Back in the day, not only did more companies go public, but when they did so they were likelier to survive. In the 1970s, report the authors, 92% of initial public offerings were still listed five years later. By the decade of the 2000s, that figure had dropped to 63%. Bankruptcies among the newly listed had increased, as had buyouts from larger firms.
Which leads to the second half of the story: "The strong," as the authors write, "are getting stronger." Not only have large companies pulled away from smaller entities, but inequity has risen among the giants themselves. Mauboussin and Callahan continue, "The gap in return on invested capital between a U.S. company in the top 10% and the median has risen sharply in recent decades. Consolidation explains a large part of this. Measures of concentration … have shown a substantial increase for many industries since the mid-1990s."
Today's behemoths are eating the competition. More than ever, their assets are intangible, created from buying other companies at a premium to their book values. Acquisitions have long been derided by finance professors as "empire building"--flubs by corporate managers who judge success by their companies' revenues rather than by shareholder value. In recent years, however, such deals have frequently worked, enabling the leviathans to "exhibit increasing returns, which include very high market shares and economic profits."
I do not know if this process will continue. It may be that large-company margins have peaked, or that after a long hiatus the Department of Justice will begin to prosecute antitrust statutes vigorously, or that the gap in valuations between the market's glamour stocks and its huddled masses has become so great that value investing will rebound, regardless of such companies' fundamental performances.
However, I must pose the question because it is too important to ignore. Value investors assume that history will repeat--and in this instance, changing fundamental conditions challenge that assumption.
John Rekenthaler (firstname.lastname@example.org) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.