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Buying Losers Might Work for Stocks, but Not for Funds

The contrarian signal doesn’t translate well.

John Rekenthaler, 03/24/2017

On the Cheap
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. Many companies that made it into Graham’s portfolio had been previously terrible stock-market performers.

Fifty years later, 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.

A few years later, Ken French and future Nobel Laureate Eugene Fama put Graham’s hypothesis to the exhaustive test. Using the largest database of U.S. stock performance then assembled, they found that they could predict future returns solely by sorting on the single price measure of book-to-market. The correlation was imperfect, to be sure, but the conclusion was unavoidable: Baskets of cheaper stocks tended to outgain more-expensive fare.

Theory Into Practice
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 DFLVX, 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 DFSVX 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.

is vice president of research for Morningstar.

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