Q: Given the value-oriented approach of the All Asset strategies, how concerned are you of investing in “value traps”?
Robert Arnott: “Value trap” is a term with no universally agreed definition. Does it mean investments that look cheap, but with enough future bad news to more than justify the low prices? Or investments that look cheap on their way to zero? Let’s begin with a self-evident truth: mean reversion cannot happen from a level of zero. Once the price of an investment goes to zero, that investment is gone. Ben Graham drew a sharp distinction between a drop in price and a permanent loss of capital. When we proclaim a “value trap” after experiencing a price decline, if the underlying profit potential of our investment is largely unimpaired, we make a dangerous error. Bargains do not exist in the absence of fear, they are created by inflicting pain on the way down (unless we can pick the exact bottom, as I noted last month!), and there are always a myriad of reasons to avoid buying bargains.
A “value trap” is an investment that seems cheap, but which is permanently impaired. Unsurprisingly, they are lousy investments. How often do companies inflict a permanent loss of capital? Let’s assume a permanent capital loss is represented by a 90% stock price decline in three years or less, with no recovery in the next three years. At any given time only about 5%1 of all stocks in the broad U.S. market may be deemed so-called “value traps.” These are rare events for stocks; for broad asset classes they are almost nonexistent.
Asset classes, representing a broad group of securities, are inherently diversified. They may get cheap, then cheaper, and finally cheaper still, but collectively, they don’t fall to zero, as individual stocks2 might. Of course, there will undoubtedly be “value traps” across multiple securities, but would an entire asset class vanish? Would all emerging market equities or all commodities concurrently go to zero? Not likely.3 In our world view of entrepreneurial capitalism, when old companies fade from view, newer and faster growing companies take their spot, eventually gaining a share in the economy.
We believe markets seek fair value, which means mean reversion can be a powerful force in the capital markets. Using the longest individual histories for each major asset class since 1975, we observe when each asset class experienced a substantial annual decline, as represented by a two-standard deviation plunge below its long-term historical average. By definition, these market shocks are extreme events, occurring less than 2% of the time. What percentage of asset classes, collectively, recovers fully within five years? If we performed the same exercise on each stock in the Russell 1000 Index since 1975, how many will recoup these severe losses?
As Figure 1 demonstrates, asset classes recovered far more brilliantly than individual stocks, after extreme events. More than half the time, asset classes recouped severe losses within three years. Within five years, asset classes recovered over 85% of the time! The odds tend to be in one’s favor. As for individual stocks within the Russell 1000 Index? It doesn’t even come close. Only 10% of disaster stocks recovered within three years, and only one-third in five years.