“The variance of happiness is how we are doing comparatively”

-Annie Duke

In September of last year I wrote about the declared death of small cap value investing (link). It was no secret at that time that US Large Cap Growth stocks had been dominating just about every other segment of the market for an extended period. Have things improved for small cap value since September? Short answer, no.

The Results

Initially things were looking pretty good for small cap value after that post, here are the results from 09/2019 – 12/2019:

That short run of outperformance appears to have been a head fake, as small cap value stocks have been those most impacted by the COVID-19 pandemic. Here are the updated results from 09/2019 – 04/2020:

Much of the dispersion in returns can be explained by underlying sector exposures of the funds. For example, the Russell 1000 Growth has close to 50% of its assets in healthcare and technology. The DFA US Small Cap Value Fund has nearly 50% between financial services and industrials.

Thinking in Bets

Most people would agree that technology and healthcare businesses will be more consistent going forward and you should tilt your portfolio towards them. Meanwhile with a projected extended period of low interest rates and an economy that will be in and out of lockdown for some time, they would also suggest we shun financial services and industrials from our portfolios.

One might argue “Mark, small cap value stocks are cheap because they are full of terrible companies in terrible industries”. It’s important remind ourselves that terrible businesses can be great investments at the right price, and great businesses can be terrible investments at the wrong price.

Imagine betting on a college basketball game (which I don’t recommend). It’s obvious that North Carolina will beat Duke every single time because they are the far superior team, but it isn’t good enough to bet on North Carolina as the winner, there is a point spread that they must overcome. The betting market knows North Carolina will win, but the point spread might be North Carolina minus 20, meaning they must win by at least 20 points for you to win the bet.

The odds are also baked into stock prices. In a recent Q&A with investment firm, Research Affiliates, they state the current market price of Amazon stock is assuming both sales and earnings growth of over 20% annually for the next decade, which would imply Amazon would be 5.4% of US GDP by 2029. For comparison, Walmart’s sales are currently 2.40% of GDP.

Buying Amazon today, you are prepaying for those expectations and they are lofty but not impossible. If they miss on those expectations you may not be a happy investor, even though it seems likely that Amazon will continue to be a great business.

The expectations for many firms falling into the small cap value bucket is quite low, which is how they ended up there in the first place. Let’s get some historical context on how this played out in eras of similar relative sentiment.

Relative Valuations

In a recent post by O’Shaughnessy Asset Management they highlight the fact that the earnings yield spread between small cap value stocks and large cap growth stocks is in the top 1.7% percent of all historical observations. In the few times this has happened previously, small cap value went on to outperform large cap growth by 16.80% annually over the subsequent decade.

Further, in November of 2019 AQR Capital Management published a piece showing that outside of 1999 technology bubble, we have not seen value stocks this inexpensive relative to growth (and the spread has widened since then):

The tech bubble popped in 2000. From the start of that year through 2007, DFA Small Cap Value earned 13.91% annually while the Vanguard Growth Index earned -1.18%.

Is It Different This Time???

That’s the key question. Could things really be different this time to where investing in small cap value is no longer a viable strategy? I’d suspect that was the case being proposed in 1999 and there is a lot of chatter about it today as well.

Unfortunately, investing in segments of the market that do not track the overall market too closely can be a psychological burden. We feel better about failure when many people share it with us. The variance of happiness is how we are doing comparatively, even though it shouldn’t be. In the pursuit of premium long-term returns, we must endure feeling premium stupidity for uncomfortably long periods.

Implementation

It would unlikely ever be prudent to invest all your assets into a strategy like small cap value, and other academic factors have shown to diversify the risk of small cap value quite well. Using a barbell approach with a fund that provides exposure to momentum stocks, or high relative profitability can help dampen some of the underperformance when it occurs.

It’s important to analyze the underlying exposures of these funds though, because they could end up just cancelling one another out.