Several months ago, we back tested S&P 500 performance using a very simple fundamental model to show that fundamental ratios applied consistently can produce outsized returns. In our original example, we rebalanced a model portfolio annually with the cheapest 100 stocks in the S&P 500 based up trailing EV/EBITDA (Enterprise Value to Earnings before Interest, Taxes, Depreciation, and Amortization). The portfolio is equal weighted. This top quintile valuation approach applied each year produced annualized returns that significantly outperformed the annualized returns of the S&P 500 from 1994 through 2012.
Obviously, 2013 was a big year for the S&P 500, with the Index’s total return finishing at 32.38%. How did the simple/passive EV/EBITDA strategy work out?
Quite well, actually. Buying the 100 names in the S&P 500 with the lowest trailing EV/EBITDA ratios (as gauged by Bloomberg) on 12/31/12 would have returned 46.79% this past year. Therefore, since the end of 1994, the simple portfolio has returned 14.57% per annum vs. 9.62% for the S&P 500. Keep in mind that the model portfolio numbers from the back test aren’t inclusive of dividends unlike the S&P 500 returns.
Like last time, there are a few caveats.
First, while the numbers from the simple back test significantly outperform over time, just because the names come from the “value” category doesn’t mean they offer shelter in the storm when markets become volatile. Annual standard deviation for the model is higher at 22.6% versus 20.1% for the index. The largest yearly loss for the passive model is -40.97% in 2008, almost 4% below the -37% number posted for the S&P 500.
Second, as we pointed out last time, fundamental models like this can be very streaky. The simple back tested model underperformed the S&P 500 for the first five years of the time period, 1995 through 1999, admittedly a tough time for value type names relative to their cousins in the growth category. Since the end of 1999, the simple model has only underperformed in two years: 2008 and 2012. No doubt, as with any strategy, there will be another sustained underperformance period for this simple model. John Maynard Keynes (may have) famously said, “Markets can remain irrational longer than you can remain solvent.” A twist on this might be, “Fundamental market models can underperform longer than you can maintain your scant patience and sanity!” The abandonment issue can become particularly acute when you have clients leaving in droves because the portfolio has underperformed. Ask many value types that managed portfolios and managed to survive through the late 1990s. Though proven right over time, investors left in droves. It’s easy to talk about patience and long-term success, but it’s hard to stick to ones guns in the short to intermediate term when career pressure builds. Of course, it’s the greed/fear career preservation psychology that keeps many from outperforming over time.
Third, and perhaps a corollary to the second point, the above performance shows how much of an impact simplicity and process discipline make in portfolio success over time. Often, investors are attracted to the notion of using complex ideas and theses to achieve success. We all love intricate tales. This example shows that simple reversion to the mean fundamental techniques work when selecting individual names. A macro portfolio example might be the simple 60/40 equity/bond passive portfolio which has outperformed many indices over time with better risk metrics. Again, having the patience and confidence to execute a simple process through good times and bad is trickier than most people understand.
While this simple test focused on EV/EBITDA, other studies produced over time with different fundamental ratios such as price to book and trailing P/E ratios also show statistically significant outperformance over time. Reversion to the mean gives us exploitable “free lunches.” Unfortunately, the gulp factor intervenes when its time to pull the trigger on undervalued investments. In any given year, many of the names on the buy lists that produced the above results would have been the names showing up in the financial press with negative stories attached or with a string of negative sell-side analyst quotes in the margins. At the end of the day, the itch to chase what’s working and to shun what hasn’t been working is far too strong for many humans.
