Long periods of feast and famine are endemic to smaller-cap value stocks, but the strategy has fueled some of the best performance.
A diversified portfolio of smaller-cap value stocks has been one of the best performers on Wall Street over the past 45 years.
We know because of the performance of an advisory service named The Prudent Speculator, edited by John Buckingham. It is celebrating its 45th birthday this month, and my performance auditing firm has been tracking it for 42 of those years. Over this period, according to my firm, its model portfolios on average have beaten the Wilshire 5000’s total return by an annualized 2.9 percentage points — 14.8% to 11.9%.
Since most advisers don’t even match the return of the market, and those who do beat the market do so by less than 2.9 annualized percentage points, this performance puts the service in the upper echelon of advisers. No other service tracked by my firm has come close to matching its long-term performance.
That should go a long way toward reassuring anxious value investors who, in light of large-cap growth stocks so dominating the market for the past 15 years, are wondering if the approach is no longer worth betting on. The Prudent Speculator beat the market by so much prior to the past 15 years that it could lag over this most recent period and still come out well ahead for long-term performance.
These long periods of feast and famine, which are endemic to smaller-cap value stocks, provide a big clue as to why the newsletter has been so successful: It’s had the patience and discipline to stick with its smaller-cap value focus even during those times when it wasn’t beating the market. Investors would do well to cultivate the same patience and discipline themselves.
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The key role played by these traits is too often overlooked. We think that market-beating performance must be caused either by well-timed market timing calls or shrewd stock picking, or both. But neither can fully explain The Prudent Speculator’s top ranking.
For example, with few exceptions, the service’s model portfolios over the past four decades have been fully invested. That means that stock picking instead deserves the credit, right? Yes and no. While stock picking is where the service devotes the bulk of its energies, it can’t explain why the service has done so much better than many other value-oriented advisers.
That’s because The Prudent Speculator isn’t the only value-oriented advisory firm that focuses on a similar array of stock selection criteria, such as the price-to-book ratio, the price-to-earnings ratio, free cash flow yield, dividend yield, financial safety and quality, and return on equity, to name just a few.
But many of those other firms, either because they lack the courage of their convictions or because their clients won’t tolerate multiyear periods of lagging the market, end up straying from the value orthodoxy.
This phenomenon, known as style drift, first entered into investors’ consciousness during the go-go years of the 1990s, when the inflation of the internet bubble led value strategies to significantly lag the overall market. A growing number of advisers who claimed to invest in value stocks began to surreptitiously invest instead in growth stocks. Something similar has been happening in recent years.
One data point that reflects The Prudent Speculator’s patience and discipline is the length of time it holds a stock after purchasing it. On average currently, for example, the stocks in the service’s model portfolios have been held for more than five years. Because those portfolios lagged the broad market by more than three annualized percentage points over the last five years, it couldn’t have been easy for editor Buckingham to stick to his guns. But he did.
Another indication of what patience and discipline look like in practice came after the 1987 crash. In that crash, the worst in stock market history, the Dow Jones Industrial Average fell 22% in just a single session, and the newsletter’s portfolios lost significantly more. In contrast to almost everyone else, who reacted with panic, the late Al Frank, who was then editor of the service, told subscribers to not only hold on to all their stock positions but buy more with any available cash.
Or take what Buckingham told clients on March 9, 2009, the exact day on which the 2007-2009 bear market came to an end. At the time, of course, no one knew that it was the bottom. And even though the newsletter’s portfolios were sitting on more than a 60% loss from where they stood at the October 2007 bull market high, Buckingham told clients that “our long-term enthusiasm [for stocks] remains intact.”
Buckingham’s enthusiasm for smaller-cap value stocks remains just as strong today as then. Below are the five smallest stocks on his recent buy list, ranked in ascending order of market cap. Notice that their forward P/Es are well below those of the S&P 500, and have higher dividend yields. Note also that a diversified portfolio is especially important with smaller-cap value stocks, so the five listed below are illustrations rather than a fully formed portfolio.
(Full disclosure: The Prudent Speculator is one of the newsletters that pays a flat fee to have its returns audited by my tracking firm. Because all newsletters pay the same flat fee, there is no incentive to make any one newsletter come out on top. Also relevant: Prior to the past six years, my firm operated under a different business arrangement in which monitored newsletters did not pay a fee to have their performances audited. My firm reports that The Prudent Speculator’s performance relative to the S&P 500 has been worse over the past 7 years than it was in the prior 35.)
