4 Questions (and Answers) About Value Investing

Will the ride continue?

John Rekenthaler 13 June, 2014 | 17:06
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Things Change
Robert Huebscher of Advisor Perspectivesan online publication with many fine (and free!) articles, recently posed four questions about value investing. He offered his own answers, which are sound and which I recommend that you read, but he also wondered about my thoughts. Here goes.

Is there an economic reason why small-company and value stocks have performed well historically?
(For clarification: The tactic of investing according to a single characteristic, such as the company being small or its shares trading at relatively low price multiples (that is, value stocks), has many names. The approach may be called purchasing anomaliesfactors, or risk factors. Recently, it has been dubbed smart beta. As that reeks of smart marketing, Morningstar prefers instead the term strategic beta. Anomalies, factors, risk factors, smart beta, strategic beta ... different ways of saying the same thing.)

Actually, there is some question whether small-company stocks really do all that well. The "small-company effect" was the first academically documented anomaly, as Rolf Banz’s 1981 paper predated the initial academic research on value investing, and was once widely believed. It stands to reason that smaller companies are riskier businesses than are larger firms, and thus deliver higher returns. But performance over the past 35 years has been disappointing, particularly when the theoretical gains are adjusted for the hard reality of transaction costs.

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John Rekenthaler  is vice president of research for Morningstar.

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