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That clearly leaves equities as the preferred risk asset, by and pardon the inadvertent but
relevant pun default. But what sort of equities ?
History offers some useful clues.
James OShaughnessy in his book What works on Wall Street conducted extensive research on
common stocks in the US market. Perhaps the most compelling strategy for delivering attractive
long term returns came from value investing.
OShaughnessy analysed a 3,000 stock universe over a period of 52 years. For each year he
identified the 50 most expensive and least expensive stocks by a variety of metrics. He then
rebalanced that 50 stock portfolio each year, ensuring that only the most and least expensive
stocks were retained. The results were instructive.
If you had bought the 50 growth stocks with the highest price / earnings ratio, for example, after
52 years, a portfolio with an initial value of $10,000 would have grown to $793,558. That sounds
like a decent return. Until you compare it with a portfolio comprising the 50 stocks with the
lowest price / earnings ratio. This value portfolio, with an initial value of $10,000, would have
grown to $8,189,182.
If you had bought the 50 growth stocks with the highest price / book ratio, the results were even
more extraordinary. Your initial $10,000 would have compounded, over time, to $267,147. But if
you had bought instead the 50 value stocks with the lowest price / book ratio, a portfolio with a
starting value of $10,000 would have grown, over time, to be worth $22,004,691.
A period of 52 years is a statistically meaningful period of time. The OShaughnessy study strongly
suggests that over time, value completely trumps growth. A bias to value may not work every
year, but its unlikely that any strategy will. Value investing requires an element of patience, not
least because it has much in common with contrarian investing, and it takes time for the crowd to
appreciate, or be taught at its own expense, that its wrong.
But the problem today for the conventionally minded is that many traditional markets are
expensive. The US stock market, for example, currently accounts for over 56% of the MSCI
World Equity Index. Anybody benchmarked against the MSCI World is obligated to own US
stocks to a greater extent than those of any other market. Robert Shillers cyclically adjusted price
/ earnings (CAPE) ratio for the S&P 500 index currently stands at 27.3. On a CAPE basis, the US
stock market has only realistically been more expensive twice in history once in 1929, and once
in early 2000. Its long run average is 16.6.
Not all stock markets are as expensive as those of the US. Roughly 70% of the US market trades
on a price / book ratio, for example, above 2 times. Roughly 40% of the Japanese stock market
(which incidentally accounts for just 8.7% of the MSCI World Equity Index) trades on a price /
book ratio of less than 1. So it should hardly be a surprise to learn that within our own fund, for
example, Japan is our single largest country exposure. Or that Asia accounts for the majority of
our holdings. Asia, by comparison with Europe, we would suggest, has, on average, superior
demographics, superior prospects for economic growth, a far lower welfare burden, and a
healthier banking system. At a time when headlines are dominated by the travails of the euro zone
and a deeply indebted West more generally, the real investment news is quietly been made
elsewhere.
Tim Price is Director of Investment at PFP Wealth Management and co-manager of the VT Price Value
Portfolio (www.pricevaluepartners.com).
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