Trading below Net Current Asset Value
What percentage of students in a typical high school would be classified as part of the in-crowd? I'm confident that people's responses to that question are dependent on where they felt they were ranked in the popularity caste system back in their school days. Former students on the outer ring of popularity (including financial advisors such as myself who advocate a less-than-mainstream value investing philosophy) probably estimate a smaller popularity percentage in comparison with the former captain of the football team or his cheerleader girlfriend. Let's classify the cool kids in a typical brick-and-mortar high school as representing twenty-five percent of the entire student body. Many students aren't part of the in-crowd but are eager to gain their peers' acceptance, hoping to move up on the popularity totem pole. However, unlike high school, popularity is something to be avoided, not sought-after, when it comes to selecting stocks for a portfolio.
In their academic study, Roger Ibbotson and Thomas Idzorek provide compelling evidence that the least popular stocks had performed the best over the long run.¹ They define individual stock popularity as the monthly number of shares traded divided by their total shares outstanding. The monthly figures are tallied up for the year, with stocks classified into one of four popularity categories, from least to greatest. Over the 40+ year study period, stocks that fell into the bottom 25th percentile in terms of popularity had almost double the average annual return of that of the most popular stocks at the other end of the spectrum (see chart). The evidence shows that when it comes to investing in the stock market, it pays to be plain and uninteresting. These super-popular stock certificates should be grateful they're not running for the homecoming court. I doubt members of any high school investment club privy to this stock popularity study would cast a vote in their favor.
Original data taken from "Risk and Return within the Stock Market," by Roger G. Ibbotson and Daniel Y.-J. Kim. Working Paper, Zebra Capital. January 14, 2014.
Could the average investor constrained by limited capital implement this popularity stock selection approach in real time? The study used 3,000 large-cap stocks as their universe of potential choices before classifying each one into its designated popularity quartile. Every year, stocks were reevaluated based on their popularity ranks and categorized into their appropriate groups. Dividing the maximum theoretical number of stocks into four quartiles translates into an upper bound of 3,000/4 = 750 stocks in each popularity grouping. In order for an investor to implement this stock selection approach by taking advantage of the highest returns in the least popular quartile, a total of 750 stocks would need to be purchased. As of this writing, no exchange-traded fund or mutual fund exists that follows this buying criterion to the letter, and most individual clients don't have the financial resources to purchase such a large number of individual stocks. What is an individual investor to do?
The answer is to set aside popularity as a buying criterion and to embrace Benjamin Graham's value investing philosophy for the enterprising investor. The strategy involves purchasing only stocks trading below net current asset value, an approximate measure of a public company's minimum liquidation value. The value investing filter is far more selective than some broad measure of popularity is, relieving a capital-constrained investor of the burden of purchasing such a large number of stocks. Unlike the best-performing popularity quartile that held 750 stocks, the average number of stocks in a Graham deep value portfolio was only 16 over the identical time period.
Graham's filtering criterion of purchasing stocks trading below net current asset value shows an even greater average return than the best performing quartile in the stock popularity study does. Having a weighting of no more than five percent in any one stock trading below net current asset value, Graham's deep value stocks outperform the best-performing popularity quartile by about one percent on an annual basis.
* No more than a five-percent weighting in any one stock trading below net current asset value. In years where fewer than 20 stocks were available for purchase, the balance was invested in treasury bills. Annual rebalancing occurred in the portfolio with dividends, and transaction fees were included in all of the calculations.
A one-percent greater average annual return may seem trivial over the long study period, but for an investor starting out with a $10,000 portfolio of stocks trading below net current asset value, that translates into well over a million dollars more in total market value. Generating a higher average return over the long haul following Graham's disciplined value investing philosophy sounds fantastic, but the primary reason to use the stock selection approach is that it can be implemented in real time when starting out with limited capital.
Is there a way to "juice up" the unpopular quartile of stocks by combining it with some value investing stock selection criterion? The authors didn't illustrate a table in their study showing any run-of-the-mill value investing filter applied to the least popular quartile, but they did investigate it. They mentioned that if such a filter were included within the least popular quartile of stocks, the results didn't line up neatly to enhance the average return. It appears that popularity and value investing are best left to hang out on the weekends at separate high school parties in order to avoid any future altercations.
The superior average performance of deep value stocks versus unpopular stocks should in no way be construed as an assault on the efficient market hypothesis. It is a simple observation that for an investor who is not fortunate enough to be born or to marry into a family of means, he or she still has a shot at accumulating significant wealth over his or her lifetime by investing in value stocks. Investors should purchase not just unpopular stocks but outright grotesque ones using a deep value criterion. The investment philosophy may pay extra dividends at a late-stage high school reunion by moving one up on the popularity index.
¹ "Dimensions of Popularity" by Roger Ibbotson and Thomas Idzorek. Journal of Portfolio Management Vol. 40, No. 5, 2014.