In a 2012 paper written by Robert Novy-Marx, we found the following statement particularly interesting:
“Strategies based on gross profitability generate value-like average excess returns, even though they are growth strategies that provide an excellent hedge for value.”1
Why did this catch our attention? We have been noticing that the value style had been underperforming. From a portfolio perspective, few things are better than adding a strategy that has the potential to “zig” as another “zags.”
Value vs. Quality
Value investing has been popularized over many decades, with names like Benjamin Graham and Warren Buffett contributing to its acclaim. The word “patience” comes up a lot, and it is not atypical for there to be periods of time where questions like “Has the value premium
run its course?” become fairly common. Still, we ask, has it ever been a poor long-term strategy to attempt to buy low and sell high?
Quality is a concept that, intuitively, has been on investors’ minds for a long time, even if the word has only been coming up with greater frequency more recently. Warren Buffett’s long-time partner, Charlie Munger, made the following statement in a speech that, to us, beautifully sums up the concept of quality:
“Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you’re not going to make much different than a 6% return—even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.”2
It’s interesting that the Buffett–Munger partnership at Berkshire Hathaway is seen as one of the most powerful in history, embodying a powerful example of the potential for combining two different styles.
The Last 10-Years: Quality or Value?
WisdomTree launched its first fundamentally weighted
Indexes focused on dividend
-paying stocks 10 years ago. Today we ask two distinct questions:
1) Which has tended to outperform, quality or value, over the most recent 10-year period?
2) Where does the most recent 10-year period fit within the broader historical context of all available rolling 10-year periods?
Value Faced a Headwind; Large-Cap Quality Faced a Tailwind
United States: High Book to Market minus Low Book to Market for Large Cap and Small Cap Companies (Rolling 10-Year Average Annual Returns) June 30, 1926 to March 31, 2016
United States: Robust Operating Profitability minus Weak Operating Profitability for Large Cap and Small Cap Companies (Rolling 10-Year Average Annual Returns) June 30, 1963 to March 31, 2016
• Value Trending toward Its Worst 10-Year Relative Returns:
What we see here for value is the difference in average annual rolling 10-year returns for stocks with high book-to-market value ratios
(value stocks) and stocks with low book-to-market value ratios (growth stocks). Whether one is looking in large caps or small caps, the result—a trend of deterioration in rolling 10-year returns—is quite clear. In large caps it is also notable that for the most recent 10-year period the growth stocks actually outperformed the value stocks.
• Quality Added Value in Both Large- and Small-Cap Stocks:
In contrast with what we noted on the value side, quality stocks—shown here as the difference in rolling 10-year average annual returns of stocks with robust operating profitability minus those with weak operating profitability—with robust operating profitability outperformed in both large caps and small caps. Additionally, the most recent 10-year period saw above-average outperformance of stocks with robust operating profitability for the large-cap size segment.
The Value & Quality Complementarity Rings True
Citing Robert Novy-Marx, we said at the outset that quality can be a hedge for value. In future blog posts, we will explore a concept that we define as the income factor and how WisdomTree’s original dividend Indexes may have been tapping into both quality AND value over their live history.
Robert Novy-Marx, “The Other Side of Value: The Gross Profitability Premium,” Journal of Financial Economics 108(1), 2013.
Charlie Munger, “A Lesson on Elementary, Worldly Wisdom as it Relates to Investment Management & Business,” speech given at USC Business School, 1994.