The True Power of Value Investing Lies in Market Unpredictability

During their latest episode of the VALUE: After Hours Podcast, Taylor, Carlisle, and Rasmussen discussed The True Power of Value Investing Lies in Market Unpredictability. Here’s an excerpt from the episode:

Tobias: Probably the only place that was a little bit sad were the small and micros. How do you feel about small and micro?

Dan: Yeah. I think the other thing that’s worth noting is the size premium has been fairly negative. I think that when you’re thinking about value, especially deep value, you’re getting a bunch of factor exposures along with your value. If you want to own value, you’re also getting small size, almost inevitably, because that’s where all the really cheap stuff is. You’re also getting low earnings growth, you’re often getting high leverage levels. And so, you’re getting this other mix of factors along with it. I think the size factor, which has, over long periods of time, has been a fairly reliable winner, has also been sharply negative. And so, if you’ve been going outside of the benchmark to own smaller things, you’ve been getting hammered.

I think the smartest thing, as it turned out to have done over the last five years– I think you even think of the smart growth investors who all said, “Hey, look, the index is too overweight, like, seven stocks. And the benefit we provide you as active growth managers is diversifying you out of this top-heavy index.” But actually, the right thing to do is to say, “Hey, the index isn’t top heavy enough. We should own double our benchmark weight in these five stocks, and then we’re going to really kill it.” That was the right answer, and no one did that. I know one guy who did it, but almost nobody else did. And so, you’ve had this sharply negative size factor, which I think has also unintentionally hurt a lot of value investors.

Jake: Dan, if you wanted different ways of imagining reversion to the mean and you have the last 10 years of what kind of worked, and then if you looked back at the last 100 years, those things are like completely opposite of each other. What’s your argument other than just purely reversion to the mean? As an existential force in the universe, what would be your thesis for why we should expect the next 10 years, perhaps to look more like the last 100 and not like the 10 before it?

Dan: Yeah. I’m not a believer in reversion of the mean for reversion of the mean’s sake. I think that we can go on a deeper philosophical level. My deeper philosophical level is that there’s a lot we don’t know about the world. Our vision of what we know really stops when the future starts. It’s really hard to predict the future. Really, really, really hard to predict the future. And if you’re a smart quant and can go back test things, you can put in a lot of ideas and you can see how hard it is to predict the future by looking at how many of your back tests fail or how many of your good ideas don’t work, right?

I think if you think about some very simple rules that you might come up with, you might say, “Gee, I think the US has outperformed last year. So, it should outperform next year.” Or, like, “US stocks always outperform.” You run that through that, you just realize it’s not true. It’s too simple. I think the fundamental reason for this and why value works in my mind is that, one of the things that’s most unpredictable is future growth rates of companies. Future growth rates of companies are totally unpredictable. Right now, it doesn’t seem like that because we have in our mind, Microsoft and Amazon and Facebook. And so we think, “Oh, gee, you know, this has been very stable long-term growers. Surely growth is predictable.” But it really isn’t. Even within the technology sector, revenue growth, earnings growth, it’s not persistent, it’s not predictable. You can test that any which way.

So, if you stop and say, “Well, gee, I don’t know what the future is going to hold on a company level for revenue or earnings.” I think it would be crazy for me to say, I really know that the US market is going to be the best performing market or really to pick any region and just say, “Hey, in 2024, that region is definitely going to be the best.” What’s the logic for that? I think the same with sectors. It’s just really hard to predict what’s going to happen with any fidelity. The world is so unpredictable. And so, then I think if you think about what that implication for that is, like, if you start with a position of future nihilism and say, “Okay, let’s assume I know nothing about the world. I absolutely know nothing, and nothing is predictable and everything is totally random.”

Well, then if you bought a bunch of companies at 5 times earnings and a bunch of companies at 25 times earnings, a year from now, in theory, the multiples should adjust for some other random new set of expectations. And so, everything should be sort of scrambled. And if everything’s scrambled, the cheap stuff is going to be much more likely to be scrambled up and the expenses stuff is more likely to be scrambled down on the random distribution. And so, value is going to work because of this resorting.

I think over time, if you look, and that’s how value works. You take the universe of value stocks and a decent chunk of them end up resorting out of value, and that’s where you make your money. With growth stocks, a big chunk of them resort down out of growth, because the growth doesn’t live up to expectations. And so, I think that, for me, value is a way of betting on unpredictability of saying, “Hey, it’s a humble way of investing.” You’re saying, “Hey, gee, I think there’s a lot we don’t know. I think there’s a lot we could be surprised by.” I don’t think we should feel too confident in our forecasts.

I think to go back to the other side of the trade where people have been very confident and they’ve been saying, “Hey, we really think that large cap US tech is the place to be, and it’s really growing a lot, and that’s going to really reward equity investors.” The frustrating thing is that they’ve been right. And so, they’ve felt that the world is very predictable and that predictability will continue. But even if you look at the predictability of the revenue and earnings growth rates of those companies, they’re really random. They’ve been really high, but they’ve been quite random. They haven’t been necessarily predictable.

And so, I think you come from this place where you say, “Gee, I don’t know what’s going to happen. I think the world is unpredictable. Value is the right way to bet.” I think when it comes to thinking about size, I think of size as, which is obviously interrelated with value. But I think there are a number of ways to think about that. One is to think that there are a lot more small companies than large companies. There’s a lot more randomness associated with it. There’s a lot more volatility. And so, gee, if you’re taking that risk in smaller stocks, you should be more rewarded to the upside when that random occurrence happens than you would in a much more large stable stock, and you’d think that the large stable stock would be more efficient or less volatile, anyway.

So, I think there’s an argument that taking this value risk within small caps gives you this really asymmetric set of outset. And if you just keep making that bet over and over and over again, you’re going to be right, because you’re betting on a fundamental truth about the world, which is, that the future is unpredictable. It just is. [chuckles] You can’t predict the future, and there are very narrow ways you can. But by and large, it’s unpredictable, and value is a way to express that bet.

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