Roelof Salomons – Kempen Capital Management/University of Groningen
Institutional investors need to take the lessons of Nobel laureates in economics on board in their plans for 2014 and beyond.
The announcement that Eugene Fama, Lars Hansen and Robert Shiller won the 2013 Nobel prize came at an opportune moment. Although Fama and Shiller, in fact, originate from competing schools of thought and are considered direct opposites in their views on economics (efficient market versus irrational market), they have a lot in common. Both argue that the valuation of financial assets is of upmost importance; the implication being that expected long-term returns are predictable to a certain degree.
Much of the work that Eugene Fama published reveals the efficiency of financial markets. Since the late 1980s, however, he has written a lot of work on anomalies, together with co-author Kenneth French. Besides the small-cap effect, which yields over 2% extra annually, they also published a substantial amount of research on the even greater value premium. Acquiring businesses at less than book value has yielded over 4% extra annually in the US since 1926, without exposure to any additional risks at portfolio level. The same value premium can be observed in other stock markets as well. Within a stock market, it is profitable to buy cheap stocks and avoid the more expensive ones. Low-priced stocks are often tainted; these are stocks that no one wants to have in their portfolio and that are excessively punished. High-priced stocks, on the other hand, often raise high expectations that they are unable to meet. Investors extrapolate and start to become irrational, which creates a window for opportunity.
The work of Robert Shiller centres on irrationality. Not only did he analyse the bubbles in the housing market and the exuberance in the stock market, he also contributed to groundbreaking research into the predictability of stock markets. Together with John Campbell, he showed that in the long run, stock market valuations will revert to their long-term average. He published this work at the height of the internet bubble. The conclusion being that investors are heading for disappointment if they expect that high price-to-earnings ratios portend above-average profit growth. Prices rather than profits are the driving force behind valuation fluctuations. As valuation ratios are slowly mean reverting processes, the theory is that predictability increases with the length of the investment horizon.
The recurrent theme in the works of both Nobel laureates is that investments in undervalued companies and stock markets yield higher returns. Evidently, this is not the case in every consecutive year, but in the long run, it is a profitable proposition, and a predictable one at that. Fama and Shiller present two lessons. First of all, investors with a long horizon should give valuations a prominent place in their long-term expected returns. This is the only way to ensure realistic expectations. In view of the current high valuations, these are rather moderate, unfortunately. Secondly, investors should have a pronounced tilt in their portfolios towards cheaper companies. The expected return on stocks may then be moderate, but capturing the value premium may help to jack it up a little. Due acknowledgement of the role of valuations in the investment process is entirely justified.
Roelof Salomons is Chief Strategist at Kempen Capital Management. In 2005, he completed a doctoral thesis on the predictability of stock markets. He lectures on investment theory and practice at the University of Groningen.