Value and Glamour Investing, Re-Envisioned

Did you know that the best performing glamour stocks outperform the best performing value stocks? Sounds exciting, right? Well it may be, but expensive stocks still stink. In this piece I visualize the performance of value and glamour stocks (inspired by and originally designed by the director of research at OSAM, Chris Meredith) in a new way to make the point once more that value trumps everything. 

Why in the world do people buy expensive stocks? Every shred of academic evidence shows that they underperform over the long term, and yet we keep buying.

We do this because we are so focused on the spectacular possible outcomes when we should instead be focused on the more sobering probable outcomes. I’ve referred to expensive stocks as lottery tickets in the past, because while investing in a group of expensive stocks (or lottery tickets) is usually a bad idea, sometimes you’ll get a winning ticket.

In the case of glamour stocks, these winning tickets have yielded incredible returns. Last October, Tesla and Cheniere Energy were the two most expensive large stocks trading in the U.S. Tesla was priced at 15 times its sales, Cheniere at 35 times sales. And yet over the next year, Tesla was up +51% and Cheniere +88%. People see results like this and think “valuations be damned.”

I define glamour stocks as the most expensive 10% of the market (rebalanced annually) by measures like p/sales and p/earnings. Glamour stocks as a group do poorly, but digging a little deeper we see that some are huge winners. Within the glamour stock universe, I sort stocks based on their forward 12 month return into ten equal groups.  The average results are illuminating:

You notice that the best performing glamour stocks beat all stocks by an average of 115% over the coming year. Talk about winning the lottery. But here is the problem: the median glamour stocks lost to the market by -11%, on average and the worst glamour stocks lost by 75%. Over and over again, we are seduced by the possibility of earning huge excess returns and blinded to the probability that we will underperform the market. Probabilities are boring, possibilities are exciting. But probabilities are all that matter in an uncertain world.

The first lesson, as always: some expensive stocks kill it, but the category stinks.

There is a flip-side which is much more enticing. Howard Mark’s (and many others successful investors) always highlight the importance of asymmetry in the investing process. The best way to succeed is to follow a strategy which is skewed in your favor on the upside.

In a recent memo, Marks said, “The goal in investing is asymmetry: to expose yourself to return in a way that doesn’t expose you commensurately to risk, and to participate in gains when the market rises to a greater extent than you participate in losses when it falls.  But that doesn’t mean the avoidance of all losses is a reasonable objective.  Take another look at the goal of asymmetry set out above: it talks about achieving a preponderance of gain over loss, not avoiding all chance of loss.” (his emphasis)

With that in mind, check out the same results for the value portfolio:

This shows that value investing offers the right kind of asymmetry that investor should seek: on average there is more to gain than to lose, because while some value stocks get killed, the average ones significantly outperform the market on an annual basis.

Glamour/lottery stocks, by contrast, have the wrong kind of asymmetry: some do exceptionally well, but the average ones significantly underperform the market.

It is fascinating that if you could see the future, you’d do the best if you bought the best of the glamour stocks: the best performing glamour stocks outperform the best performing cheap stocks. But you can’t predict the future, so don’t try. Forget the splendiferous possibilities of glamour stocks and focus your portfolio in value stocks that offer the highest probability of success.