From O'Shaunnessy funds:
January 1, 1999
The philosopher Soren Kierkegaard said that "life can only be understood backwards; but it must be lived forwards." The same is true of the stock market. Today's market events or conditions often blind us to the bigger picture, preventing us from focusing our long-term investment goals. So let's take a look backwards, review what's happened in the market recently, compare it to the past, and see what history can teach us as we move forward.
Where We've Been
Since 1994, the stock market has been extraordinarily biased toward big-cap growth stocks. Virtually all of the returns generated by the S&P 500 this year are due to the stunning performance of just a handful of big growth stocks--the top 10 performers in the index accounted for 56% of the S&P 500's returns through the end of November. If your large-cap stock wasn't a Microsoft, Pfizer or Lucent, chances are it was flat for the year.
As for stocks outside the big-cap growth arena, this year's market has been a virtual wasteland. Value and small-cap stocks have suffered terribly. According to the December 27, 1998 New York Times, "If it seems that your value stocks are spinning their wheels, it probably isn't a reflection of your stock-picking prowess. Last month, the difference in 12-month performance between the S&P/Barra Value and S&P/Barra Growth Indexes was the largest in 11 years." In other words, value stocks really stunk in 1998.
The December 28, 1998 Barron's headline on the Dogs of the Dow Strategy (a large-cap value component of our Dogs of the Market Fund) was even less encouraging: "Bound for the Pound? Dogs of the Dow lag sadly behind for the third straight year." Yes, after just a few years of underperformance, the folks at Barron's are ready to screw the pooch. So what if the Strategy has been a stellar performer since 1928. It's always: What have you done for me lately?!
And if you want to see really bad, all you have to do is take a look at small-cap stocks. Those laggard big-cap value strategies look positively wonderful when compared to the plight of small-cap stocks. The small-cap Russell is down more than 7% as of December 24, 1998. And even that figure masks the true shellacking the average small stock has endured--25% of the stocks in the Russell are down more than 50% from their highs this year! And if you look at our O'Shaughnessy Small-Cap Universe (7,964 stocks with market-caps below $1 billion), you'll see a median loss of 15.07% between January 1, 1998 and November 30, 1998. (In contrast, our small-cap Cornerstone Growth Fund was flat through the end of November.)
With this sad state of affairs in the value and small cap categories, some wonderful opportunities have been created. The PE differential between the Russell and the S&P 500 is at an historic low of .78 (it usually trades at a much higher premium of 1.1 or more). This means small-cap stocks are extremely cheap compared to large-cap growth stocks.
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"Don't worry about people stealing your ideas. If the ideas are any good, you'll have to ram them down people's throats."
~ Howard Aitken ~
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It's been a long and lonely draught for small stocks. Even though history shows that small capitalization stocks outperform large stocks over almost all long periods of time (someone investing $10,000 at the start of 1929 would have $18.5 million more if he simply held small stocks rather than the S&P 500) there are some long periods where the patience of Job is required. Luckily, I believe we're near the end of big-cap growth's out-sized performance and a renaissance for value and small-cap strategies. Why? Look at history.
Where We're Going
I believe this week marks a historical opportunity for small stock investors. For the first time since the mid-1960s, large stocks will outperform small stocks over the 20-year period ending December 31, 1998. So, rather than be distraught about the market, I find myself delighted! For if history is a good guide, we can expect small cap stocks to embark on a multi year rally that will send them soaring above their bigger, better known brethren that currently dominate the S&P 500.
What's So Special About Big Stocks?
Big stocks have been clobbering small stocks for years now, and some investment advisors are actually recommending stocks just because they are big! But big stocks aren't really such a big deal. In What Works on Wall Street, I showed that the S&P 500's returns over the last 45 years could be virtually duplicated by simply buying stocks with greater than average market capitalization's (i.e., large stocks). Had you invested $10,000 in the 25 largest stocks by market cap in 1951, your investment would be worth $2.2 million on December 20th, 1998. The same investment in the S&P 500 would be worth $2.4 million, a small difference, indeed. (Remember that $10,000 invested in a small-stock strategy like Cornerstone Growth turns $10,000 into $24.7 million over the same period.)
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"Whenever you have a group of people thinking the same thing at the same time, you have one of the hardest emotional causes in the world to control."
~ J. M. Barker ~
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The same thing has happened over the last five years. Had you invested $10,000 in the 25 largest-cap stocks on December 31, 1993, your portfolio would have grown to $30,609 by December 20th, 1998, a compound return of 25.07%. At the same time, the S&P 500 had a 23.16% compound return--another pretty small difference, especially when you consider that the first portfolio contains 475 fewer stocks than the second!
What Have You Done For Me Lately?
Unfortunately, most investors focus on the trees rather than the forest. They look at what has performed best recently--and expect the trend to continue. Rarely do they study the past--and look what happened after big stocks have had their run. And that is the strategic investor's crucial advantage. By looking at history, we know that the last time large stocks outperformed small stocks for a 20-year period, the small fry went on to dominate for years. Since 1928, there were only four 20-year periods (out of a possible 51) when small stocks lagged large stocks. Someone understanding this important historic relationship between small and large stocks would see that small stocks are a great opportunity right now.
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"The less a man knows about the past and the present the more insecure must be his judgment of the future."
~ Sigmund Freud ~
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Let's say you know that, over 20-year periods, small stocks almost never do worse than large stocks. And let's say you use such an occurrence as a signal to buy small stocks aggressively. The first time small stocks lagged large stocks for 20 years was in 1964. Over the ensuing 4 years, small stocks' performance exploded. Look at these returns:
Year S&P 500 Ibbotson Small
Stock Index Difference
1965 12.45% 41.75% +29.30%
1966 -10.06% -7.01% +3.05%
1967 23.98% 83.57% +59.95%
1968 11.06% 35.97% +25%
Someone investing $10,000 in small stocks at the start of 1965 would have $32,901 at the end of 1968, a gain of 229% in just four years! The same $10,000 invested in the S&P 500 returned a comparatively modest 39%, with $10,000 growing to just $13,926.
What Can Cornerstone Growth Do for Me?
The potential of small-cap stocks is very exciting right now. But history shows that you can enhance small stocks' return by using a strategy like Cornerstone Growth. What if, rather than buying the Ibbotson Small Stocks Index in 1965, an investor used Cornerstone Growth? Here are the results:
Year
Ending: 25 Largest
Stocks S&P 500 Ibbotson Small
Stock Index Cornerstone
Growth Strategy*
1965 8.84% 12.45% 41.75% 44.10%
1966 -10.21% -10.06% -7.01% -0.10%
1967 22.43% 23.98% 83.57% 83.30%
1968 6.70% 11.06% 35.97% 50.50%
$10,000 becomes: $12,766 $13,926 $32,901 $39,713
I find the current valuations of small stocks extremely compelling. But no one rings a bell and announces it's time for us to move from big-cap growth stocks to small-cap stocks. It takes foresight and courage to buck the big-cap growth trend, yet that is what history is telling us to do. So, as if on cue for our investment philosophy, Winston Churchill said: "The further backward you can look, the farther forward you are likely to see." |
