My investment advisory firm is located within a five-minute drive of the Mississippi River here in the St. Louis metropolitan area. Not long ago, I heard a tall fishing tale from an underwater welding specialist who repairs bridges along the Mississippi River. The oversized dimensions he described of a river catfish that brushed alongside him while he was doing some repair work on an arch bridge sounded almost unbelievable. There are similarities in the way a bottom feeder catfish hunts for food and in the way an enterprising investor finds undervalued securities using a selection approach that Benjamin Graham wrote about in his book The Intelligent Investor. I can't imagine Graham, a self-made millionaire and Ivy League academic, enjoying the idea of having his ideas compared with a stinky fish swimming in the muddy Mississippi, but let's do it anyway. Both the catfish and the enterprising investor find value in things that others have discarded as worthless. In the case of a bottom feeder catfish, it gobbles up morsels of discarded food and other dead critters that eventually make their way to the river bottom. Deep value investors rummage through the neglected remains of stocks that other investors have rejected, snatching them up at bargain prices for inclusion in their portfolios.
As illustrated in The Net Current Asset Value Approach to Stock Investing, a simple strategy for purchasing these bargain basement stocks outperformed both a large- and small-cap index fund by a significant margin over the long term.
Just as an outlandish fishing tale can be hard to believe, it is unbelievable to imagine an investment world where deep value stocks can be scooped up at a price point below what stockholders would receive if the company were put on the auction block in a full liquidation sale. Not only do the stocks exist but also the chart shows them outperforming both a large- and small-cap index by nearly double the annual return over the course of the long study. When an average return of a time-tested value investing criterion is compared with that of an index fund, the results always favor the former if long-term stock data are used in the comparison. But what if the investing river from which we snag our stocks is choppy and rough? Would an investor still be interested in owning these volatile stocks? Many investors might not take a shining to a selection of bargain basement securities if the stock market were to crash and deep value stocks experienced an even greater portfolio drawdown than an index fund did.
Most investors psychologically find losses in their portfolio to be twice as powerful as gains are, and this is consistent with academic evidence in behavioral finance. This implies that over the short term, risk-averse investors would rather avoid a major portfolio drawdown than have an exciting opportunity to make the big bucks on some high-flyer stock IPO. This preference for risk aversion holds true even among the subset of retail investors who shun expensive growth stocks and spend most of their time fishing for deep value plays.
From an emotional standpoint, if losses sting more than capital gains feel prodigious, should an enterprising investor avoid the value investing approach outlined in the writings of Benjamin Graham? Let's compare the worst return(s) on a Wilshire Small-Cap Index with a portfolio of deep value stocks. Using a holding period of one to 10 years, the chart below shows the worst annualized return on the Wilshire Small-Cap Index. During those terrible performance streaks when small-cap stocks bomb out, the matching return from a deep value portfolio doesn't take quite the hit.
The lower downside risk in comparison with small-cap stocks isn't all that surprising. Small-cap stocks are more volatile than the overall stock market is, so when stocks are trending lower, they generally fall further in value. When only looking at time periods of poor performance, the deep value portfolio has an advantage over a volatile small-cap index. Bargain basement stocks are already beaten down before entering the portfolio. These value stocks have gotten a head start before the clock starts to tick and you begin the return comparison against a small-cap index. As shown in the chart, the mining of the average returns in a stock database for the biggest losing streaks favors value stocks over a volatile small-cap index.
Does that still hold true if a portfolio of deep value stocks is compared with a less volatile large-cap index? We know from the data that smaller stocks on average fluctuate more than large-cap stocks do, so the time periods of the worst performance might tilt in favor of a larger-cap index fund. Most retail investors who believe in index fund investing are locked into a fund that mimics the S&P500 index, not a more volatile small-cap index. The S&P500 is a market-cap weighted index that includes 500 of the largest public companies listed on a U.S. exchange. Let's see if these loser time periods pulled from the rubble still favor value stocks over the less volatile S&P500 index. The chart below shows the worst annual return(s) over different rolling periods when the S&P500 stunk about as bad as a dead fish rotting along the river shoreline.
The evidence shows that comparing a deep value portfolio with the lower volatility S&P500 index still favors the value stock portfolio. Some of the time periods with the biggest losses during the past 60 years occurred in the recent past. The worst three-, four-, and 10-year loss periods for large-cap stocks all took place within the past 15 years.
Is volatility, as measured by the standard deviation of returns, greater for deep value stocks than for the S&P500? The answer is yes, but so what? As already pointed out, investors are more sensitive to losing money than to making it. The standard deviation is interesting from an academic standpoint, but focusing on worst-case returns rather than on a statistical calculation used to measure risk seems more appropriate when ranking different investment strategies based on investor preferences. Avoiding deep annual drawdowns is more important to the average investor than routine monthly portfolio volatility is.
If the objective is to lessen the sting of stock ownership during years of loss, deep value stocks dominate both a small- and large-cap index fund. Although large-cap stocks are less volatile than small-cap stocks are, neither index wins out over the bargain basement value stocks as far as avoiding losses is concerned. I'm not a culinary fan of Mississippi River catfish. The idea of eating a fish that swims along the bottom of a river, swallowing up everybody else's crap, doesn't sound all that appealing. Trolling along the bottom of the stock market river and picking up deep value stocks is a whole other story. Money doesn't buy happiness, but losing money in stocks doesn't, either. Investing in deep value stocks that other investors have thrown overboard is one way to reduce exposure to losses when the overall stock market inevitably hits a rough patch. Come in for the big win by focusing on neglected stocks that float along the bottom of the river. Happy hunting.
