When an investment strategy is declared as “dead” or “no longer working” there’s a reasonable chance it is about to work again. Take for reference this article from CNBC posted in November of 2008, The Death of Buy and Hold. The article claims that buy and hold investing is broken and no longer a good strategy. BUT If you would have purchased a fund tracking the S&P 500 Index on 11/01/2008 and held it through 06/30/2019 you would have made 281.47% (minus fees and taxes) without ever making another trade during that time frame. That’s not what I would call “dead”.

Of course there’s also the infamous, “What’s Wrong, Warren? article that Barron’s posted at the end of 1999, which questioned whether or not Warren Buffett had lost his magic touch due to Berkshire’s significant underperformance. Since the turn of the century through August of this year, Berkshire A Shares have outperformed the market by 4.48% annually. Buffett does not seem to have lost his magic touch.

The Recent Underperformance of Small Value

It’s no secret that U.S. small cap value investing has taken a shellacking over quite an extended period now, while large cap growth stocks have performed very well. Let’s look at the numbers over a previous 5 year period. We’ll use the S&P 500 as our proxy for the U.S. Stock Market, and the Russell 1000 Growth Index to measure the performance of large growth stocks:

The relative underperformance of small cap value may be surprising to some, and has many asking whether or not this is still a viable asset class to offer a return premium going forward. One question to ask is “has underperformance of this nature happened before?”.

To answer this question, I have posted the returns below of another 5 year period of significant underperformance:

A Reason for Optimism

No two periods are exactly alike, as the tech bubble of the late 90s caused growth stocks towards obscene valuations. But similar to the most recent 5 year period, this period of the 90s saw the market favoring growth stocks over small cap value by a wide margin.

What followed was a tremendous run of outperformance for small cap value:

The Long-Term Data

Now let’s get a long-term picture of the full period from 01/01/1995 – 06/30/2019:

Profivalue?

Using large cap profitability historically has helped diversify against the risks of investing in small cap value stocks, as there is very little correlation at all between the excess returns offered from companies with high relative profitability and companies that fall into the small cap value bucket.

The problem with investment strategies like this is that many people like to track the performance of the broad market when it is going up, and nobody wants to track the performance of the market when it’s going down. In order to capture the returns of a strategy that could offer long-term outperformance, you have to give up tracking the market. In order to earn a return that is better than the market return, you have to look different than the market.

Style Valuations

One reason large cap stocks have outperformed is they started out more largely discounted. Here are what valuations looked like at the end of September in 2011:

*Source: JP Morgan Guide to the Markets

Large Growth stocks were trading at just 63.50% of their 20 year average price to earnings ratio, while small value was a little closer to its 20 year average. Now let’s see where valuations stand today:

*Source: JP Morgan Guide to the Markets

Now just about every style box is trading above its 20 year average price to earnings ratio with the exception of small cap value stocks, the growth segment of the market is trading far higher than it has been in the past. That does not mean it is overpriced, there are always more factors to consider.

Systematic Rebalancing

If you have had a dedicated portion of your portfolio towards small cap value stocks, this could be a favorable time to rebalance. As shown above, the performance of profitability and growth have been significantly better on a relative basis, which means your desired weight towards small value may now be much less than the original design of your portfolio. Also, systematic rebalancing of your portfolio could be a good way to sell some of your winners to buy your losers (as painful as that can be).