In last week’s post we extended the systematic value factor (or at least a pretty good proxy of it) back to 1871. The response from readers was encouraging, perhaps because of the pain that value investing has been causing lately. Long-run history gives some relief. This week we dig deeper, reconstructing another 46 years of unseen history. As a result, we now have an extra 100 years of data for systematic value investing.
Thanks to Professor Goetzmann’s U.S. stock price and dividend data, we can do a VERY ROUGH approximation of the value factor back to 1825, using stock-level dividend yields.
To address two objections upfront: “dividend yield is not value” and “deep history is irrelevant today”.
We admit that dividend yields are a far cry from a value composite. But back in the 19th century, dividends played a much greater role than they do today. Companies were not as focused on growth, and buy-backs did not exist as they do today. Finally, most definitions of price to fundamentals have a large common component. Hence, though approximate, looking at dividends yields as the original value factor is still informative today.
As to the '“why look at long-term history” question, I agree that there are many differences between today and two hundred years ago. At the same time, deep history contains key insights that are not visible in recent history, especially about risk. The following quote summarizes it well:
“The reasons for covering as long a time period as we can with consistent methods should be obvious at this time. Historical data show the kinds of human experience that have taken place, and, perhaps, their relative frequencies. But each period also has its own special features. To ignore all data from the 1920s, 1930s, and early 1940s in estimating the riskiness of investments in common stock—as many did in the late 1960s—now appears to be foolhardy. Older data could be ignored safely only if risk were much better understood.”
- Lawrence Fisher and James Lorie (Founders of the CRSP database), “A Half Century of Returns on Stocks and Bonds” - University of Chicago, 1977
A few technical notes:
In total, there are 256 securities that exist in both the annual dividend file and the monthly price file. The average monthly number of securities with both dividend and price data is significantly lower - just enough to construct the traditional factor-thirds.
To increase coverage of the monthly dividend yields we use the average two-year dividend and divide it by the two-month average monthly price, which is lagged by 12 months. Making this adjustment does not materially change the results (a difference of 4 basis points per month), but creates just a touch of extra robustness.
For the monthly total returns, we use changes in the month-end prices and add the annual dividend yield divided by twelve.
We manually review all the returns for outliers. Having worked with this data-set for many years, since 2008, we are familiar with the raw data ‘fat finger’ issues that need to be corrected.
For the “Goetzmann” period 1825-1871, every month we construct the value factor by ranking and assigning stocks into thirds based on their dividend yield. We show both the top and bottom third excess return vs the average of all stocks and the long-short top minus bottom excess return without the risk-free rate.
For the “Cowles” period 1872-1926, we use the industry value factor described here.
For the “Fama-French” period 1926-2020, instead of traditional HML, we use Top 30 minus Bottom 30 univariate sorts B/M portfolios, to align with the extended history methodology.
Here are the results:
Here are 5 take-aways from the extended history:
The -59% value crash as of March 2020 is on the very extreme side of an almost 200 year history.
Yet over the long-run, Value crashes of -50% appear ‘normal’. Well, they happened at least four times before the current one, if you count the -49% crash in 1862.
Without the help of long history, and before the current drawdown, investors might have mistaken value investing as safe.
Back in 2006, which is when systematic value investing started to go mainstream, investors could see just one value crash of -54% back in 1932.
It was easy to dismiss it as part of a ‘very different history’ that was no longer relevant. Investors made a similar incorrect assumption about Price Momentum before it crashed in 2009.
With the help of extended history, the hypothetical 2006 value investor, warned about the periodic crashes, would estimate value’s risk differently, and as a result, would be less hurt during the current drawdown (I think it’s time for Excel to recognize dates before 1900).
1940 to 2006 was an exceptionally safe period for value investing compared to its full history. And this tailwind helped many great value investors, creating unrealistically high expectations for value investing.
For example, the Graham-Newman partnership years only saw the lowest value drawdown of -40% in 1939 - just three years after their partnership started. From then on, value rallied with minimal drawdowns during the twenty years that they operated with astonishing 20% per year returns (13% of which could be attributed to the top decile of book to value Fama-French portfolio).
Warren Buffett was also a benefactor of the 50-year low-crash-risk period that ended around 2006. He is now navigating the worst value drawdown in his very long investment career.
Value investing, like any investing, looks like a never-ending series of drawdowns, with tiny intervals of absolute gains in between.
For example, out of 2332 months of value’s history, only 266 were not in drawdown - slightly over 10%. And yet when you look at the cumulative return, you barely notice the drawdowns, because the long-term compounding starts to deliver its magic.
In the end, I believe all investing comes down to balancing the two outcomes: drawdowns and average returns. And deep history can help us set the right expectations about both.
So here we are, in a very different time and economy, and value crashed again.
Unfortunately, 2020 demonstrates that history does repeat itself, albeit in unexpected ways. Only in 1904 was the crash similar to its current strength.
The current value crash is challenging investors to make a tough decision: is value investing the riskiest or the safest thing to do now? If history is to continue repeating itself, then value should do pretty well going forward.