Investors who are familiar with Stratus’ investment philosophy know that we build portfolios based on the risk profiles of our clients. In order to do this, we focus on investing based on risk factors that have proven to be robust to different measurement specifications, that are able to be replicated in markets around the world and that are persistent throughout different time periods. We believe that investing based on rigorously defined risk factors allows an investor to target risk prudently, leading to portfolios that are based on the positive relationship between risk and return.
One of the best known examples of risk factor investing is to purchase shares of value companies. Value companies are those that tend to be out of favor and/or provide products or services that are vital to our economy but do not make headlines. A good example of a value company is Cisco Systems, one of the larger technology companies in Silicon Valley. While it does not make eyecatching products such as iPhones or Kindles, it provides the infrastructure that allows the internet and data centers around the world to function, supporting services like cloud storage, which are vital to the utility of our iPhones and Kindles.
Stocks of value companies have been shown to outperform those of growth companies over time but in order for an investor to capture this value premium they need to have patience and a consistent allocation to a diversified portfolio of value companies. For example, over the past 3, 5 and 10 years ending February 2016, growth stocks (as measured by the Russell 1000 Growth Index) have outperformed value stocks (as measured by the Russell 1000 Value Index) on an annualized basis. This data would lead most investors to question whether or not there is a value premium and, more importantly, if a value premium does exist, whether or not it is worth trying to capture.
While we cannot predict the future, it can be instructive to look at previous periods to gain some insight into how the value premium works. It is important to remember that just because value outperforms growth over time does not necessarily mean value will outperform growth over every conceivable time period. For example, the technology boom of the late 1990s was another period when growth stocks greatly outperformed value stocks. By the end of 1998, an investor in value stocks would have lagged an investor in growth stocks over 3, 5 and 10 year periods (similar to the current trend). This trend continued throughout 1999 and into the beginning of 2000. At this point, it was understandable that some investors and their advisors bailed out of value stocks due to an underperformance versus growth stocks of almost 5.00% per year over the previous decade.
However, once the market had broken the will of numerous value investors, it corrected itself with shocking speed. By February 2001, value stocks had outperformed growth stocks over 3, 5 and 10 years. More importantly for long-term investors, value had also outperformed growth over the previous 20 years ending February 2001 by roughly 1.60% per year, even though growth had greatly outpaced value through the latter part of the 1990s. Similarly, even though the past decade has been a better time to be invested in growth stocks (as compared to value stocks), the longer term picture still favors value, with value outperforming growth by approximately 1.02% per year over the past 20 years. While no one can accurately predict the future, we believe that history has an important lesson to teach investors about discipline when investing based on risk factors. For the investor who
outlines their risk tolerance and builds a strategy based on risk factors, appropriate rewards can be harvested if that investor is willing to stick to their investment plan over different market regimes.