Expected Sources of Premium Stock Returns Part I: Managing the “Daring Adventure”

When Helen Keller said, “Life is either a daring adventure, or nothing,” she probably wasn’t thinking about the stock market … but she could have been. Recently, some investors have been wondering whether it still makes sense to pursue expected returns from small-company and value stocks. That’s understandable, as investing in these two asset classes has indeed been a daring adventure lately, with relatively disappointing returns.

Are small-cap and value investors experiencing a temporary set-back to be pushed through, or is this a permanent change calling for revised strategy? The short answer is, while we cannot guarantee certain outcomes, we believe it still makes sense to pursue the return premiums offered by small-company and value stocks. Nothing has altered our evidence-based expectations about their long-term performance. In this four-part series of posts, we’ll explain why this is so.

First, let’s set the stage: Why focus on small-company and value stock premiums to begin with? Why not pursue other characteristics, such as companies with the most Facebook likes, or those whose names begin with the letter “B”? What’s so special about size and value?

It’s Academic… and Practical

First, we base our asset class selections on academic inquiry to identify potential investment premiums that seem worth pursuing. Academic study goes above and beyond casual analysis. It requires rigors such as peer review and a disinterested outlook. Once academia identifies a potential premium, we also need to confirm that it can be effectively captured in our real-life investing. Combining theory and practical application, we look for the following qualities:

  • • Sensible: The rationale for the premium has to make economic sense.
  • • Persistent and Pervasive: The benefits of the premium need to be seen across long time periods and across markets.
  • • Robust: We should be able to calculate the premium in a number of different ways.
  • • Cost-Effective: We must be able to capture the premium in a cost-effective manner, net of trading costs, tax consequences, and any other expenses.

Once we crunch all the numbers in theory and in practice, across the decades and around the globe, we are left with three major sources of return in the global stock markets. They are:

  1. Company Size
  2. Relative Price (Value vs. Growth Stocks)
  3. Profitability

In our next post we’ll address the durability of these factors by reviewing their average historical return premiums.

 

About Chas Boinske

Charles P. Boinske, CFA, is a 30 year investment management veteran overseeing the strategic direction and portfolio management process for Independence Advisors, LLC. Have a question for Charles? CLICK HERE TO ASK CHARLES

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