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The triumph of value stocks

2016 was a great year for value investors - but defensives and momentum also did well
The triumph of value stocks

Last year was a good year for UK equities; the FTSE 350 rose by 12.5 per cent in the year. You’d expect, therefore, that it would have been a good year for high-beta stocks – those that are most sensitive to moves in the general market. But you’d be wrong.

My high-beta portfolio (which comprises the 20 stocks with the highest beta in the previous five years) rose by only 9.4 per cent in the year, which is not only less than the market but also less than the 10 per cent gain in our low-risk portfolio

In truth, this tendency for lower-risk stocks to beat high-beta ones is a standing one. Over the last 10 years, my low-risk portfolio has beaten the high-beta one by over 60 percentage points. Nor is this a quirk of my data. In fact, this tendency was first in US equities by Michael Jensen, Fisher Black and Myron Scholes way back in 1972

Performance of no-thought portfolios  
 In Q4In 2016last 3 yearslast five years
Momentum4.215.828.892.2
Neg. momentum6.338.2-24.6-20.2
Value3.337.732.9108
High beta39.4-27.118.7
Low risk-3.71017.345.8
Mega caps2.812.62.419.4
FTSE 3503.112.5734.4
Price performance only: excludes dividends and dealing costs

 

As for why this should be, Andrea Frazzini and Lasse Heje Pedersen at AQR Capital Management have provided one explanation. It's that basic textbook theory is wrong, because it ignores important institutional features of investment.

This theory says that if investors are bullish on the market they should reduce their cash holdings or borrow and buy more of the market generally. Many investors, however, do not do this because their mandates require that they be more or less fully invested at all times and because there are tight limits on what they can borrow. Such investors express their bullishness not by increasing their leverage but by buying high-beta stocks – those they believe to be geared plays on the market – and selling low-beta ones.

Because most investors are bullish most of the time (remember that there should in theory be an equity premium) this means that, most of the time, high-beta stocks will be overpriced and low-beta ones will be underpriced. The upshot is that high-beta stocks will do less well than they should and low-beta ones will do better. This is exactly what we’ve seen not just in the UK market but in international stocks and (as Frazzini and Pedersen show) in other assets, too.

Two of our portfolios, however, did do extremely well in 2016. Value stocks (the 20 highest yielders) and negative momentum (the worst fallers in the previous 12 months) both rose by well over 30 per cent in the year.

There’s a simple reason for this. At the start of the year, many mining stocks were bombed out because of fears about the Chinese slowdown. Such stocks thus featured heavily in both our high-yield and negative momentum portfolio. As these fears receded, these stocks bounced back massively.

In the case of value, this fits the long-term pattern. Very high yields are often a sign that a share is exposed to a lot of cyclical risk: it will do badly in a downturn but well in a recovery. For this reason, recessions (or the fear thereof) are bad for value stocks but recoveries good.

This explains the longer-term performance of my value portfolio. It did disastrously badly in 2008-09: before the crisis it was builders and mortgage lenders who were on the highest yields, and some of these such as Bradford & Bingley and Northern Rock were wiped out. As the economy recovered and cyclical risk paid off, however, value stocks bounced back nicely. </p><p>In this sense, value stocks are very different from high-beta ones. In the case of high-beta, high risk usually means low reward. In the case of value, however, risk is rewarded. In individual stocks it is cyclical risk that pays off, not market risk.

This year’s good performance of negative momentum, however, is not part of a pattern. Quite the opposite. Past losers usually carry on falling. Even including this year’s bounce, my negative momentum portfolio has done badly over the last five years.

One reason for this is that investors tend to be slow to update their beliefs in light of new evidence. When a stock suffers bad news, therefore, they continue to believe it is basically a good investment with the result that they don’t sell it sufficiently. That leaves the share overpriced despite its fall with the result that it subsequently falls further.</p><p>But why don’t smarter investors exploit this fact? The answer lies with the same sort of reason that explains the bad performance of high-beta stocks: market frictions. In theory, wise investors should short-sell past losers, thus driving their prices down to their correct levels. In practice, however, some are forbidden from doing this while many others find it difficult to do so because of high volatility and a lack of liquidity. In the absence of a major turnaround of the sort we saw this year, therefore, past losers can be overpriced and so continue falling.

This year’s good performance of negative momentum, however, does not mean that positive momentum had a bad year. Quite the opposite. My portfolio of past winners beat the market again. This continues a trend. In the last 10 years it has risen by almost 150 per cent, far in excess of the market’s return. This, of course, fits the international evidence.

As to why this should happen, part of the reason is that investors underreact to good news and so shares don’t rise as much as they should for companies that enjoy such news. Also, Victoria Dobrynskaya points out that momentum can carry benchmark risk: it exposes fund managers to the danger of underperforming their peers. This makes momentum stocks risky for them, with the result that their good performance is in part a reward for taking on such risk.

Now, I should stress here that, in one sense, the precise returns on my portfolios aren’t important. These portfolios are precise tests of what are really only  theories. For example, there’s no reason why they should contain 20 stocks rather than 10 or 30. And there’s no reason for defining momentum by returns in the past 12 months rather than the past three, six, nine month or other periods

But the fact that the longer-term returns on these particular portfolios is consistent with the global historical evidence is important. It reinforces our beliefs about how stocks are priced – namely that the basic capital asset pricing model is wrong; that momentum pays; and that value stocks carry (priced) cyclical risk.

What’s more, these portfolios are formed by simple no-thought processes. If conventional stock-picking works, you should be able to outperform them. For example, value investors should pick the best higher-yielding stocks rather than just the 20 highest yielders.

Whether this actually happens is, however, unclear. What does seem clear, though, is that there are some simple strategies that, on average and over the long run, do allow us to beat the market.</p>

Our new no-thought portfolios

Here are our new no-thought portfolios. All are equal-weighted baskets of 20 shares, drawn from stocks with a market capitalisation of over £500m, excluding investment trusts.

Megacaps (the biggest stocks): AstraZeneca, British American Tobacco, BHP Billiton, BP, BT, Carnival, Diageo, GlaxoSmithKline, Glencore, HSBC, Imperial Brands, Lloyds Banking, National Grid, Prudential, Reckitt Benckiser, Rio Tinto, Royal Dutch Shell, Shire, Unilever, Vodafone.

High beta (the highest-beta shares, based on monthly returns in the last five years): 3i, Aberdeen Asset Management, Anglo American, Centamin, Evraz, Ferrexpo, Fresnillo, Glencore, Henderson, Hochschild, Kaz Minerals, Man, Mondi, Old Mutual, Schroders, Standard Chartered, SuperGroup, Thomas Cook, Travis Perkins, Vedanta

Value (the highest dividend yielders): Aberdeen Asset Management, Ashmore, Berkeley, BP, Brown N, Capita, Carillion, Cobham, Debenhams, easyJet, Galliford Try, HSBC, IG, Pearson, Persimmon, Phoenix, Redefine, SSE, Talk Talk, Vodafone

Low risk (the lowest beta stocks, subject to no more than three from any one FTSE sector): Breedon, BTG, Cineworld, Cranswick, Emis, Esure, Euromoney, FirstGroup, GVC, Hill &amp; Smith, IG, Imperial Innovations, Indus Gas, James Fisher, James Halstead, Jardine Lloyd Thompson, Nichols, Rank, Telecom Plus, Ultra Electronics

Momentum (the biggest risers in the last 12 months): Acacia Mining, Anglo American, Boohoo, Centamin, Coats, Electrocomponents, Evraz, Ferrexpo, Fevertree, Glencore, Hochschild, Hunting, Imagination Technology, Indus Gas, Kaz Minerals, NMC Health, Petra Diamonds, Tullow, Vedanta, Weir.

Negative momentum (the biggest fallers in the last 12 months): Capita, Capital &amp; Counties, Card Factory, Cobham, Dixons Carphone, easyJet, Essentra, IG, Inmarsat, International Consolidated Airlines, Man, McCarthy & Stone, Mediclinic, Melrose, Mitie, Next, Rank, Restaurant Gp, SIG, Sports Direct.