Why Return Skewness Offers Some Hope for Value Investors

By Jack Forehand, CFA (@practicalquant)

It is no secret that value investing strategies have struggled for a long time now. The extended period of underperformance has tested the patience of many value investors and has led some to abandon the approach entirely. Adding to the frustration have been the frequent calls from some well-known value investors that we are at or near the end of this period of underperformance and that value is about to have its day in the sun again.

I won’t be one of those people who tells you when value is going to turn because I think the historical evidence shows that doing so is impossible, but a look at the return profile of value strategies relative to the market does offer some reason for optimism that when things do turn, those who stayed the course will be rewarded.

You Have to Be In It to Win It

The returns of stocks in general are left skewed. What that means is that significant negative return events are more likely than significant positive ones. But the returns of value strategies relative to the market are typically positive skewed. That means that major outperforming days are more frequent than major underperforming days. When you invest in value strategies, being there for those big up days is a very important part of realizing their potential.

Let me give you some examples from the value strategies we run at Validea. If you are not familiar with our system, we build quantitative strategies based on the published writings of historically successful investors. We try to find every fundamental-based strategy we can that works over the long-term and we follow them and track their performance over time.

One of the models we follow is based on Ben Graham’s book The Intelligent Investor. Our model based on Graham is essentially the definition of a deep value model. It only selects stocks that are very cheap. On top of that, we run very focused versions of it that hold ten to twenty stocks. So if you wanted to look at a very aggressive implementation of deep value investing, this model would be it. Because it is very aggressive, it can be used as a magnified example of the return profile of a deep value strategy.  

Since its inception in 2003, our Graham model has outperformed the market by around 3% per year. But the road to get that outperformance has been a very rocky one filled with major positive and negative deviations from the return of the market.

Here are the strategy’s best five months relative to the market since its inception in 2003.

And here are its five worst.

As you can see, this strategy has very high tracking error and can be far ahead and behind the S&P 500 in any given month, but the extreme outperforming ones exceed the extreme underperforming ones. This is the positive skewness I referred to before.

It is also important to note when some of the best months occurred. Many of them were centered around either the worst periods for the market in general or periods where value investing struggled. Two of the best months both ocurred following the bear market bottom and they came in rapid succession. This strategy beat the market by over 30% in those two months alone. Two others occurred in 2017, coming off a bad relative period for value.

So as we sit through the very long period of underperformance for value we are going through now, it is important to recognize why staying the course during periods like this is so important to successfully implementing these strategies. Even if you had missed only a couple of the best performing months above out of the 193 total months in the sample, all of the strategy’s outperformance would go away. And the fact that many of these best months came directly in the wake of some of the worst ones makes it even more important not to flinch when times are at their worst.

This focused model is obviously an extreme example of this, but the same principle holds for more diversified value models.

Below are the best five months for the DFA Small-Cap Value Fund relative to the S&P 500. The fund holds hundreds of stocks, so it is the complete other end of the spectrum from the focused portfolio above.

And here are the worst five.

The results show a much less extreme version of the same phenomenon. Its performance relative to the S&P 500 is positively skewed and the best months show more outperformance than the underperformance in the worst months.

Patience is a Prerequisite

So what does all of this mean? The right skewed distribution of value returns relative to the market is a double-edged sword for followers of the strategy. On one hand, it can lead to huge outperformance over a very short period of time. But on the other, it means that waiting through extended periods of underperformance will be required to get those returns. And many of the best returns come immediately following the darkest days, so trying to time the strategy is next to impossible.

The recent decade has been very difficult for anyone following a value investing strategy. But this data does offer some reason for optimism, because things can change for the better very quickly and sometimes when you least expect it.  As is the case with pretty much everything in investing, conviction is the key to success.

Photo: Copyright: 123rf.com / lightwise

Jack Forehand is Co-Founder and President at Validea Capital. He is also a partner at Validea.com and co-authored “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies”. Jack holds the Chartered Financial Analyst designation from the CFA Institute. Follow him on Twitter at @practicalquant.