RAFI funds look to improve the standard value investing approach by not just investing just because a stock is doing badly. Does this approach improve this strategy enough?
We somehow ended up with two different terms to describe stocks, value stocks and growth stocks. When it comes to stocks, the value of a stock and its potential for growth are the same thing essentially, so it is definitely curious how we could even make this distinction.
Examining why we call these stocks value and growth doesn’t even come up very much though, as just about everyone just accepts the definition of each category and just assumes that it makes sense to separate stocks by using these terms.
It actually does make sense to have these groupings, and the mistake we make here is to call one of them “value.” It actually would be much more appropriate to call them “lack of value” stocks, at least if we understand what makes a stock valuable or not.
Not knowing what it is that makes stocks valuable is where people get off track here, and this takes them off the road of sensibility and toward a strategy that is way out of touch with reality and one that can also get you into some real trouble.
We need to start with asking ourselves why we would want to own a stock. As long as we’re talking about buying it and not selling it short, this means that we are buying and holding it with the expectation that it will increase in value.
How we decide if and how much it may increase in value may involve a number of different approaches, including looking at things like the trends of the stock, trends in the market, future expectations for the particular business, sector, the market, the economy, or whatever else.
Fundamental analysts like to focus a lot on earnings, and we can understand the value of a stock that way if we like, as long as we understand that value is to be measured by what will happen in the future.
This is not how these people tend to measure value though, sadly. What they do instead is focus on the present and look to calculate what a stock may be worth based upon how it is doing now, which will provide us with a certain valuation. We can determine things like book value this way, but this is simply not how markets value stocks, as they take into account how a company is doing now and now it may be expected to do in the future, and it’s the future expectations that provides stocks with various premiums over book value.
The traditional approach to “value” investing will take stocks that the market has determined have a poorer outlook for the future, and therefore a lesser premium added to their price, and look to prop this up as a desirable feature somehow. We can have two stocks, both performing identically, but if one has a poorer future outlook than the other, it will be a better “value,” whereas the better company will have less “value.”
The amazing thing about this thinking is that in spite of how absurd it is, it is very widely followed by a lot of investors, as well as being embraced by a lot of people who get paid to provide advice and manage people’s money.
If We Want Our Stocks to Grow, We Need to Want More Growth
Not surprisingly, stocks that have weaker outlooks tend to perform worse over time, and return quite a bit less on average than stocks that we call growth stocks because they do have better prospects for growth, and the amount of growth is how we keep score.
The proper way to distinguish these is with the terms “higher growth” and “lower growth”, with the lower growth ones the sort that people like to use the term “value” with.
Stocks will march to whatever tune the market does, and if investors decided that the prospects of a stock should be viewed according to alphabetical order, the ones starting with “A” would perform the best, and those starting with “Z” the worst. We don’t do it that way, but we could, if we really believed that this was the way to do it.
There was a time, many years ago, when people used to bottom-feed with stocks that had been performing badly, and they called this strategy “reversion to the mean.” A stock would go down a lot, people would get excited and buy it, and this caused some positive momentum and you could make money that way sometimes.
This also stopped happening a long time ago, as it was not based upon anything that made sense. Stocks can only revert to their mean present value if present value is what matters, and with stocks, it simply does not. Instead of being the only thing, like many people think, it isn’t even something of any real importance.
Let’s say we’re comparing two companies again, of similar present earnings. One stock is priced twice as high as the other. The market therefore expects the higher priced one to do better, which essentially means expectations of the future stock of the price, but if we prefer, we can call that future earnings growth if we prefer.
Stocks that are seeing high earnings growth that propel their price tend to continue to grow this way, with their stock prices growing right alongside. Stocks with limited future prospects tend to continue to have a bleaker future and their stock prices will then tend to continue to portray this lesser value.
When we bet on a stock, and do so sensibly, we are betting that the company’s earnings will grow by a certain amount in the future. Positive expectations take us away from the mean, where the mean is average expectations, and those below this have inferior expectations. The better our stock’s company does in the future, the more it will revert further from the mean, which is a sign of progress, not a deficiency that is subject to correction by normal forces.
With laggard stocks, we would need a good reason for them to reverse their course and start looking better, and this also does not happen by way of any invisible hand but does require a real improvement in outlook. Taking a view in such opposition to reality is simply a terrible way to try to invest.
The RAFI strategy seeks to use what we could call a hybrid means of valuation, looking at other things such as revenue and cash flow and less at things like earnings to price ratios. There are several other approaches in fact that look to avoid assigning value purely based upon an inversion, where those that actually have more future value get shunned in favor of those which clearly represent less opportunity for returns and therefore less actual value.
Is the RAFI Strategy Focused on the Right Things?
Rob Arnott, the founder of Research Affiliates, who developed the RAFI strategy, boasts that this approach “breaks the link” between a stock’s perceived value and its underperformance in the markets. That is a good idea, but does this break the link enough?
Funds like Invesco’s RAFI US 1000 ETF use this approach, and are touted as a way to take advantage of a value rally if it ever comes, while still being able to hang with the market at least reasonably well.
There is no doubt that many people are still clinging to the idea that value rallies may not be extinct and somehow the market will decide one day to forget about future value and just value things based upon present value. This really is as ridiculous of a notion as it sounds.
Once again though, we do need to understand that a stock’s price represents its perceived future value to get this, and there are a great many that do not get this. They just look at the present and the very near term and believe that they understand everything that you would ever need to know about what a stock should be valued at, and anything beyond that just doesn’t factor in. When their confused calculations differ from reality, reality is believed to be out of whack and should be expected to revert to their limited and mistaken views. They are still waiting.
For a time in September, poor stocks actually beat the better ones, and even this happening over just a couple of days is enough to get a lot of the crowd out of their seats. This fizzled though because it really makes no sense to have the sustained bets made on bad stocks in favor of good ones for too long, because things like earnings growth do actually matter, and poor here isn’t the ideal or goal.
The idea that we could ever get such a weak stock rally that could somehow be sustainable over the time frame that investors use, meaning over a decade or more, would require that the investing world set aside the future growth of a company mattering, and this is just not going to happen.
Invesco’s RAFI ETF is being positioned as something that more conservative investors should be interested in, and conservative investors may indeed require a different approach, but is this one a good approach for them?
Any time we discount the future in our stock or company analysis, this will yield below average performance. This ETF does invest in some companies that have fabulous growth, but they seek to limit this to the point where the return of the fund can’t keep up all that well with the market itself.
For example, this EFT has only returned 35% over the last 5 years, compared to the S&P 500’s 50%. The market also soundly beats this over any period over the last 10 years, during this growth phase, and if you’re looking to grow your money and the market is growing, you want to be in stocks that are growing as well.
If the market isn’t doing well, we need to ask ourselves whether we should even be holding stocks, even though it is so entrenched in the creed of investing. It’s not just about seeking the best returns, it is doing this in a way that we can manage our risk appropriately as well, and risk management isn’t something very many investors practice very well at all.
If we are willing to give up a certain amount of return to manage risk, that’s fine, but we actually have to receive the benefit of better risk management to ever make sense of such a thing. We could have bought the market and kept 30% of our portfolio in cash and got the same return as Invesco’s ETF, and got back a 30% hedge if things turned badly.
The biggest problem with this fund isn’t that it returns less, and you can put together portfolios that return less but provide great hedges, such as utility funds, but if you just get the lower return and not the hedge, you should really be scratching your head.
This ETF actually goes down as much as the market does and therefore provides no protection on the downside, just the watered-down returns. It takes hits of all sizes similar to what the market does, anything from the 2008 crash to the dips that we’ve seen this year.
The reason for this is because while we do price in more growth with the better stocks, which become subject to bigger revisions when the overall macro view deteriorates, those nasty surprises that cause market pullbacks, those with less promising earnings growth have less to lose but they still get revised in a similar way.
When the bad times come, they will be bad for the good and the mediocre alike, but the fact that the market doesn’t like the mediocre ones that much even during the good times has them liking them notably less during the bad times.
We may not want to hold stocks that have the most growth, in other words put all our money into a stock like Apple, because when there are problems on the macro front, we will experience bigger drawdowns, although why this should matter so much to longer-term investors who will be around to ride out several of these waves is an even bigger question perhaps and one for another day.
There are legitimate reasons why some investors might not want too much drawdown exposure though, even if it just to calm their anxious minds, and this is why people don’t usually choose a very high beta portfolio. This is why we instead seek to diversify, but when you get beat pretty badly by a random selection, and you don’t even have any real benefits to show for it, it is time to re-think things.
RAFI ETFs simply focus on the present too much with the data that they look at, and while this approach isn’t quite as confused as a pure value approach, avoiding the stocks you should be buying and buying the ones you should avoid to any degree is not a sensible way to invest. This will have us getting poorer returns without not only a sufficient enough advantage, but any real advantage at all.
Those who are skittish are told that this might be something that they may like, but when the fund itself is too skittish, as RAFI ETFs are, skittish and skittish do match up here but this is a quality that we want to look to reduce and not intentionally seek.