Pick up any investment magazine, and the impression given is that investors should be looking to buy great companies. It might sound intuitive, but it's generally a bad idea. As LARRY SWEDROE explains, it completely disregards one of the basic principles of investing — the relationship between risk and expected return.
— Loren Fox
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It is July 1, 1963. John Doe is the greatest security analyst in the world. He is able to identify, with uncanny accuracy, the companies that will produce high rates of return on assets over the next 56 years.
Unlike real-world analysts and investors, he never makes a mistake in forecasting which companies will produce great earnings. In the history of the world, there has never been such an analyst. Even Warren Buffett has made mistakes, such as investing in companies like US Airways and Salomon Brothers.
While John cannot see into the future as it pertains to the stock prices of those companies, following the conventional wisdom of Wall Street, he builds a portfolio of their stocks. He does so because he has confidence that, since these are going to be great-performing companies, they will make great investments. Relating this to our sports betting story, he has identified the Duke Blue Devils of the investment world. We can identify these great companies ourselves by the fact that growth companies have high price-to-earnings ratios.
Jane believes in market efficiency
Jane Smith, on the other hand, believes that markets are efficient. She bases her strategy on the theory that if the market believes a group of companies will produce superior results, the market must also believe they are relatively safe investments. With this knowledge, investors (the market) will already have bid up the price of those stocks to reflect those great expectations and the low level of perceived risk. While the companies are likely to produce great financial results, their stocks are likely to produce relatively low returns.
Jane, expecting (though not certain) that the market will reward her for taking risk, instead buys a passively managed portfolio of the stocks of value, or distressed, companies. She even anticipates the likelihood that, on average, these companies will continue to be relatively poor performers. Despite this, she does expect the stocks to provide superior returns, thereby rewarding her for taking risk. We can identify these companies by their low price-to-earnings ratios.
As you will see, Jane believes that markets work — they are efficient. John does not. Relating this to our sports betting story, John believes that you can bet on Duke and not have to give any points when they play Army.
Should you buy great companies or lousy ones?
Faced with the choice of buying the stocks of “great” companies or buying the stocks of “lousy” companies, most investors would instinctively choose the former. Before looking at the historical evidence, ask yourself what you would do. Assuming your only objective is to achieve high returns, regardless of the risk entailed, would you buy the stocks of the great companies or the stocks of the lousy companies?
Let’s now jump forward 56 years to the end of June 2019. How did John’s and Jane’s investment strategies work out? Who was right?
In a sense, they were both right. For the 56-year period ending 2019, the return on assets (ROA) for John’s great growth stocks (Fama-French U.S. growth research index) was 10.0 percent per year. This was more than three times the 3.0 percent ROA for Jane’s lousy value stocks. The average annual return to investors in Jane’s value stocks was, however, 13.3 percent per annum—33 percent greater than the 10.0 percent average annual return to investors in John’s growth stocks. We see similar results when looking at return on equity (ROE). The ROE on growth stocks was 21.8 percent, more than three times that of the 7.2 percent ROE of value stocks.
If the major purpose of investment research is to determine which companies will be the great performing companies, and you produce inferior results when you are correct in your analysis, why bother? Why not save the time and expense and just let the markets reward you for taking risk?
Small companies versus large companies
If the theory holds true that markets provide returns commensurate with the amount of risk taken, one should expect to see similar results if Jane invested in a passively managed portfolio consisting of small companies, which are intuitively riskier than large companies.
For example, small companies don’t have the economies of scale that large companies have, making them generally less efficient. They typically have weaker balance sheets and fewer sources of capital. When there is distress in the capital markets, smaller companies are generally the first to be cut off from access to capital, increasing the risk of bankruptcy. They don’t have the depth of management that larger companies do. They generally don’t have long track records from which investors can make judgments. The cost of trading small stocks is much greater, increasing the risk of investing in them. And so on.
When one compares the performance of the asset class of small companies with the performance of the asset class of large companies, one gets the same results produced by the great companies versus value companies comparison. For the same 56-year period ending June 30, 2019, while large companies produced ROA of 8 percent (more than twice the 3 percent ROA of small companies) and large companies produced ROE of 17.3 percent (more than twice the 8.2 percent ROE of small companies), small companies (Fama-French U.S. small research index) returned 12.2 percent per annum, outperforming the return of 10.0 percent of large stocks.What seems to be an anomaly actually makes the point that markets work. The riskier investment in small companies produced higher returns.
Great earnings don’t translate into great returns
The simple explanation for this anomaly is that investors discount the future expected earnings of value stocks at a higher rate than they discount the future expected earnings of growth stocks. This more than offsets the faster earnings growth rates of growth companies. The high discount rate results in low current valuations for value stocks and higher expected future returns relative to growth stocks. Why do investors use a higher discount rate for value stocks when calculating the current value? The following example should provide a clear explanation.
Let’s consider the case of two identical (except for location) office buildings that are for sale in your town. Property A is in the heart of the most desirable commercial area, while Property B borders the worst slum in the region. Clearly, it is easy to identify the more desirable property. If you could buy either property at $10 million, the obvious choice would be Property A. This world, though, could not exist. If it did, investors would bid up the price of Property A relative to Property B.
Now let’s imagine a slightly more realistic scenario, one in which Property A is selling at $20 million and Property B at $5 million. Based on projected rental cash flows, you project that (by coincidence) both properties will provide an expected rate of return of 10 percent—the higher rental income tenants pay for the better location is exactly offset by the higher price youhave to pay to buy the property. Faced with the choice of which property to buy, the rational choice is still Property A. The reason is that it provides the same expected return as Property B while being a less risky investment. Being able to buy the safer investment at the same expected return as a riskier one would be like being able to buy a Treasury bond of the same maturity and yield as a junk bond. Thus, this world could not exist either.
In the real world, Property A’s price would continue to be bid up relative to Property B’s. Perhaps Property A’s price might rise to $30 million and Property B’s might fall to $4 million. Now Property A’s expected rate of return is lower than Property B’s. Investors demand a higher expected return for taking more risk. It is important to understand that just because Property A provides a lower expected rate of return than Property B does not make it a worse investment choice — just a safer one. The market views it as less risky and thus discounts its future earnings at a lower rate.
The result is that the price of Property A is driven up, which in turn lowers its expected return. The price differential between the two will reflect the perceived differences in risk. Risk and ex-ante reward must be related. The way to think about this is that the market drives prices until the risk-adjusted returns are equal. It is true that Property B has higher expected returns. However, we must adjust those higher expected returns for the greater risk entailed.
A basic principle investors forget
Almost everyone understands the relationship between risk and expected return in the context of this example. However, it always amazes me that this most basic of principles is almost universally forgotten when thinking about stocks and how they are priced by the market.
With this understanding, we can now complete the picture by considering the case of two similar companies, Walmart and Kohls. Think of Walmart as Property A and Kohls as Property B.
Most investors would say that Walmart is a better company and a safer investment. If an investor could buy either company at the same market capitalisation, say $20 billion, the obvious choice would be Walmart. It would be like betting on Duke and not having to give away any points. Walmart not only has higher current earnings but also is expected to produce faster growth of earnings. If this world existed, investors owning shares in Kohls would immediately sell those shares in order to buy shares in Walmart. Their actions would drive up the price of Walmart and drive down the price of Kohls. This would result in lowering the risk premium demanded by investors in Walmart and raising it on Kohls.
Now let’s say that Walmart’s price rises relative to Kohls. Walmart is now selling at $100 billion and Kohls at $10 billion. At this point the two have the same expected (not guaranteed) future rate of return — say, ten percent. Given that Walmart is perceived to be the better company and therefore a less risky investment, investors should still choose Walmart. The reason is that, although we now have equal expected returns, there is less perceived risk in owning Walmart. So the process of investors buying Walmart and selling Kohls continues.
It does so until the expected return of owning Kohls is sufficiently greater than the expected return of owning Walmart — to entice investors to accept the risk of owning Kohls instead of owning Walmart—say, a price of $200 billion for Walmart and $5 billion for Kohls. The size of the differential (and thus the difference in future expected returns) between the price of the stocks of Walmart and Kohls is directly related to the difference in perceived investment risk. Given that Walmart is perceived to be a much safer investment than Kohls, the price differential (risk premium) may have to be very large to entice investors to accept the risk of owning Kohls.
Would these price changes make Walmart “overvalued” or “highly valued” relative to Kohls? The answer is “highly valued.” If investors thought Walmart was overvalued relative to Kohls, they would sell Walmart and buy Kohls until equilibrium was reached. Instead, the high relative valuation of Walmart reflects low perceived risk. Walmart’s future earnings are being discounted at a low rate, reflecting the low perceived risk. This low discount rate translates into low future expected returns. Risk and reward are directly related, at least in terms of expected future returns—“expected” since we cannot know the future with certainty. Kohls’ future earnings are discounted at a high rate. Therefore, it has a relatively low valuation, reflecting the greater perceived risk. However, it also has high expected future returns.
Just as Property A is not a bad investment (it is a safe one) and Property B is not a good investment (it is a risky one), Walmart is not a bad investment (it is a safe one) and Kohls is not a good investment (it is a risky one). Once we adjust for risk, the expected returns are the same, and they are equally good (or bad) investments.
The moral of the tale
There is a simple principle to remember that can help you avoid making poor investment decisions. Risk and expected return should be positively related. Value stocks have provided a premium over growth stocks for a logical reason — value stocks are the stocks of riskier companies. That is why their stock prices are distressed. Investors refuse to buy them unless the prices are driven low enough so that they can expect to earn a rate of return that is high enough to compensate them for investing in risky companies. For similar reasons small stocks have also provided a risk premium relative to large stocks.
Remember, if prices are high, they reflect low perceived risk, and thus you should expect low future returns; and vice versa. This does not make a highly priced stock a poor investment. It simply makes it an investment that is perceived to have low risk and thus low future returns. Thinking otherwise would be like assuming government bonds are poor investments when the alternative is junk bonds.