Jan 23 2009
Asset Allocation: Counter Argument to Edesess
I ended the last post with this paragraph. “When I finished a careful reading of this section of Edesess’ book, I immediately went to the index to find a reference to Fama & French. My assumption was that I would find a reference to their impressive work published in the June 1992 issue of the Journal of Finance. Nothing! Not a mention of their paper. Hmm. Why not? We will need to take this up later. In the interim, readers can search this blog for references to Fama and French to see why their paper is so important when it comes to developing a portfolio plan.“ If you have yet to find information on the Fama-French (FF) paper of 1992, here is a quick summary.
The FF study spanned a period from the early 1960s through 1990 and it included nearly all stocks traded on the New York Stock Exchange (NYSE), the American Stock Exchange (AMEX), and the over-the-counter (NASDAQ) exchange. All the stocks were ranked based on price to book (P/B) and divided into ten groups. At one end of the division were 10% of the total with the lowest P/B ratio. These are considered to be the “cheap stocks” or what we sometimes call, ‘deep value’ stocks. At the opposite end were the “expensive stocks” or those with the highest P/B ratio.
Robert A. Haugen in his book, “The New Finance,” describes Book Value as follows. “Book Value is the accountant’s estimate of the value of the stockholder’s stake in the firm. To a great extent, it is based on historical cost. You start with the accounting value of the total assets of the firm, and then subtract the claims on the assets that come ahead of the stockholders’. These claims would include amounts owed to suppliers, to the bank, to bondholders, and others. What’s left is for the stockholders.” This is the Book Value.
Now let’s get back to the Fama-French study. We have all these stocks ranked by P/Book ratio and they are divided into ten groups, cheap to expensive. Once a year, mid-year as FF wanted all the information to be available for the new ranking, the stocks are re-ranked according to P/B. The ten groups are bought and held for one years. The mid-year re-ranking takes place and the stocks are bought once more, held for one year and sold. The ranking takes place again, stocks are purchased and held for another year. This process goes on for twenty-seven years.
The results were staggering and that is why this research turned into such an important and frequently cited paper. The “cheap stocks” or those with the lowest P/B ratio turned in an annualized return of 21.4% while the most expensive stocks or those with the highest P/B ratio garnered only an 8% annualized return. Further, as we go from cheapest to most expensive portfolios, the returns keep falling and there is not one exception. None.
Armed with the French-Fama research, we now tackle Michael Edesess’ contention that asset allocation is a scam. Our position is that one stands a better chance (not absolute as there is no such thing) or a higher probability of outperforming a broad benchmark such as Vanguard’s Total Market Index Fund, the VTSMX, if one tilts a portfolio toward value and smaller-cap asset classes. Fama-French say nothing about small-cap asset classes. That argument has its own set of research data. We are advocating a tilt toward value based on research done by FF and others. The Dimensional Fund Advisors (DFA) also do this with their recommended portfolios. One can see this by looking at the portfolios recommended by Index Funds Advisors at this site.
Have you ever heard the expression, good companies make bad stocks, and bad companies make good stocks? That is what FF uncovered. The “cheap stocks” or those with a low Price/Book (P/B) ratio are beaten down companies. Further, they are not always easy to find in sufficient numbers and when an investor does, there is a strong inclination to stay away and not take a chance. To the rescue comes ETFs such as VTV, VWO, and especially VBR. By taking the ETF route, we diversify and lower our risk.
While we cannot guarantee a portfolio built around a value and small-cap tilt will outperform the VTSMX benchmark, we do think there is a probability argument that favors skewing the portfolio in this direction. That is why most of the seven portfolios tracked over on Premium Content take this approach.
Lowell Herr
Photograph: Great Wall of China
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