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21-March-2006
Quality versus Growth, by Victor Niederhoffer

The market mistress is a femme fatale who is endlessly creative in luring investors to part with their chips, dignity and financial life. One of her latest dodges is always to show herself in the company of very ugly competitors so that she looks good in comparison. Take the case of all the investors in stocks who have made 5% a year over the past 5 years, an abysmal return by most standards including those relating to random selection of the average mid-cap stock which has gone up some 50% in the last 5 years. In comparison, the S&P 400 Midcap index has gone from 517 to 738 during this period.

According to a recent article by Bloomberg columnist Chet Currier, "More Fund Managers Use Bond Logic to Pick Stocks", one fund group wearing this style is the Davis Select Advisers, who "overseeing" some $60B these days, sported a 5% a year return annually over the last 5 years versus a 2.4% a year benchmark they are compared to. So enamoring was their performance that they were recently awarded the $3.6 billion Clipper Fund. They describe their style as quality investing in blue chips not selling at premium P/E's "in a time of few obvious bargains." According to a Bloomberg story they said, "Our purchases in 2005, including WalMart stores and Microsoft, reflect our desire to trade up in quality." Might I ask on a prospective basis when they might note a time when there are obvious bargains around so that I could wear that look also and trade up also.

To add a bandwagon effect to this style, the sage of Nebraska is quoted. "Market commentators and investment managers who glibly refer to growth and value styles as contrasting approaches to investment are displaying their ignorance, not their sophistication".

And yet, investors are paid for accepting risk, according to the books I have read, the courses I have taken, the articles I have absorbed, and the tests that I have run. A standard formula is that their extra returns for this acceptance of risk are equal to beta x the stocks risk premium on a market portfolio. Such a relation is derived in all corporate finance texts including one of my favorites Corporate Finance Theory  by Aswath Damodaran. A typical empirical documentation of the relation is the annual return of 17.6% for small stocks over a 66 year period versus 12.4% for all stocks. Damodoran summarizes such studies, "There is clear evidence here of a positive relationship between the variance in returns and the average returns on investment classes".

What's particularly mischievous about the current styles that show that investors to their advantage wearing quality and low variance stocks is that they set investors up to use such fashions at just the time when the climate is most likely to favor the opposite style. You see, empirical studies also show that after a period of 5 years when the overall market is flat or down, that's exactly when the returns in the future from buying the high variance, low quality stocks are best. Such could easily be documented by calculations based on the data that appear in the Triumphal Trio's book Triumph of the Optimists and doubtless one of my operatives or a reader will perform a hand study, to provide a foundation for those who don't wish to always be behind the form.

I can not leave this subject without alluding to a related fashion, this time not from the Midwest, but from the mountainous areas. The idea here is that because investors lost so much money by being long and absorbing risk in 2000-2002 that the thing they should prudently wear in the future is chronic bear apparel or fund of funds apparel to diversify away their risk.

The great English detective Horace Rumpole liked to end his cases and apprehensions of the criminal with the lament "Why does it always have to be romance?" I feel a similar craving "Why in the words of Robert Bacon does the public always lose so much more money than they have a right to lose?"

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