Fading the Fade
In part two of our video series, we examine how the best companies’ returns are not fading at anywhere near the rate that they used to in the 1990s or the early 2000s and the effects it’s had on value investors.
Click here to read the entire The Virus Plaguing Value blog.
I am going to assume that a lot of people listening to this are generally familiar with the concepts behind value investing. In case you are not, let’s do a 100 second crash course. Value investing means buying stocks at a significant discount to their intrinsic value. By doing this, value investors embed high potential upside to the purchase, and a margin of safety to the downside. There is another big related concept called the fade rate. Eventually, companies that earn high-profit margins attract competition, so these high returns tend to fade over time to a long term corporate average. In order to ensure a margin of safety, it’s important to avoid accidentally overestimating long term profits.
Value investors calculate intrinsic value with a DCF, or discounted cash flow analysis. To do this, you need to estimate future cash flows and a terminal value for the business, and discount these back to the present to account for time value and risk.
There is one huge problem with DCFs, which is that the variables are all forecasts about the future, and as Yogi Berra once famously said, forecasting is hard, especially about the future. It’s important to have some humility about the fade rate concept also – like a star athlete, eventually they become more average but it’s hard to predict exactly when this will happen.
Because of these subjective factors, value investors over the years developed a variety of approximation methods to speed up the calculation and reduce subjectivity.
In 1992, one particular speedy and practical technique was published by Professors Eugene Fama and Ken French called the “Value Factor”. They concluded that over time companies trading at below-average price to book multiples outperformed those trading at higher multiples, arguably because higher multiple stocks embedded more inflated profitability assumptions. Buying the less demandingly valued cohorts of the stock market steered investors away from this behavioral finance mistake.
From the dawn of modern record-keeping in 1960 until the year 2006, the Fama French low book to market value factor enjoyed a nearly 15-fold cumulative excess return that managed to encapsulate the vagaries of the DCF model and the corporate fade rate in one tidy package. One financial variable to rule them all.
Their work was widely embraced, and soon thereafter, a low price to book multiple became the primary manner by which value stock indexes were constructed. This means that trillions and trillions of dollars of indexed investments are linked every single day to this one variable. Ironically, this all happened in the early 1990s, just a couple years before the birth of the modern internet and the PC revolution.
This is a slide that I first saw a couple years ago. It really shook my foundations as an investor. Let me explain what you are looking at. It’s a chart produced by a quantitative finance group at Sanford Bernstein. What it shows are the future ROE’s of companies that are in the highest quintile of the overall stock market 1, 2, 3, 4, and 5 years after they first appear in the top quintile. As you can see, back in the 1990s, about half of the top quintile companies were still in the top quintile 3 years later, while after 4 or 5 years, 60-70% of top quintile companies were no longer in the quintile. In other words, the fade concept was working very reliably. Now squint a little at this chart, and you will see that some time in the mid 2000s, the slope of these lines starts to turn up. By 2015, more than 60% of the top quintile companies are still earning superior Returns on Equity 4 or 5 years later. In other words, the best companies’ returns are not fading at anywhere near the rate that they used to in the 1990s or the early 2000s.
Your typical value investor has a behavioral bias to look selectively at laggards and not overestimate the sustainability of high-profit margins. But given the data that makes up these charts, that bias is wrong. Apparently, with increasing force in the 21st century, the top companies in the stock market are able to continue compounding returns on capital at above normal rates, and competition does not seem to be making much of an impact. The whole concept of fading the extremes, and therefore book value as the most important variable, is thrown on its head. Moreover, a behavioral bias towards looking at “cheap” companies that have lagged the market by varying degrees, and embed lower return expectations, is counterproductive.
So why is this happening, and why did it start happening in the mid-2000s? Was there a rule change like in basketball that initiated a variety of unforeseeable consequences?
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