Losers in the Driver’s Seat

3 minutes reading time

Many investors will have heard the saying that a fund manager only has to get 55% of their picks right to make a lot of money. That’s because most fund managers are primarily focused on the performance of the portfolio as a whole. Portfolios provide diversification, which aids investors in managing the uncertainty that comes with picking stocks. They also give investors the chance to profit without being able to forecast the future and despite making a lot of mistakes.

But there’s a rub. The returns to stocks are positively skewed. As if that wasn’t bad enough, portfolios of value stocks are also “very much skewed to the right“. This means that:

  • The majority of stocks are poor investments.
  • Consequently investors will struggle to earn a decent return if they miss the few stocks that perform strongly.

Positive skewness is a particular problem for value stocks as they:

  • Suffer from a particularly poor base rate – 57% of low price/book stocks in the US have a negative return over the following two years (Piotroski, 2002).
  • Are often “cheap for a reason”. The best-case scenario is a temporary setback, while the worst-case ends in bankruptcy. It can be hard to tell which is the more likely outcome.
  • Are more likely to operate in distressed industries or sectors.
  • Often have fewer profitable reinvestment options for future growth (evidenced by higher dividend payout ratios and yields) which caps the upside of many stocks in the value universe.

This results in an elevated risk that losing stocks (which are more likely given the base rate) will drive the performance of value portfolios.

We can illustrate why this is the case using a simple portfolio as an example. The example is very basic but it accurately captures a pattern of returns that I’ve seen countless times in value portfolios.

Imagine that a value investor owns an equally-weighted portfolio of 10 stocks. At the end of 12 months, 6/10 earn a positive return with the best stock A earning a return of +50%, while the worst stock J loses -20%. Notice that the distribution of stock returns is consistent with what we’d expect given the returns of value stocks are positively skewed.

Portfolio A

Despite a 60% batting average and a win loss ratio of over 2 to one, the portfolio makes a 5.70% return. And that’s before taking transaction costs and taxes into account.

A 60% batting average assumes that our value investor is highly-skilled (or lucky). That is, she is skilled enough to overcome the unfavourable base rate for the return of individual value stocks.

What happens if stock A (yellow) earns a 100% return instead? The portfolio return is now a healthy 10.70% and the win-loss ratio improves to over 3:1. The batting average remains at 60%.

Portfolio B

OK, I guess you’re wondering what if happens if stock J loses -50% (orange) instead of -20%? The portfolio return drops to an anaemic 2.70%. Notice that the batting average remains at 60%. Remember this is all before transaction costs and taxes.

Portfolio C

So what’s the lesson here? In all three cases, our highly skilled value manager is getting 60% of her stock picks right. A 60% batting average would be the envy of any fund manager! She is quite literally beating the odds which suggest that she should be only getting around 44% of her picks right.

But it’s not the batting average that’s the driver of returns Its’ the presence or absence of a big winner or loser. The difference can come down to a single stock. Remember that all three outcomes are consistent with the distribution of value stock returns.

Our value investor HAS to pick at least one big winner to earn the value premium. Otherwise she has to settle for a mediocre return. Meanwhile, all it takes is one bad loser to blow it. 

And we know from the shape of the distribution of value stock returns that our value investor is more likely to pick Stock J ( big loser) than Stock A (big winner).

This is why losers are often in the driving seat for value strategies – they have a disproportionately large impact on returns regardless of the level of skill of the fund manager.

What does the typical value manager do in response? They buy more of the stocks that fall in value and sell the big winners when they reach their target price. We’ll consider this in detail parts 7 and 8 of my series on value investing.

  1. Value Investing – Don’t get Skewered!
  2. Losers in the Driver’s Seat
  3. Margin of Safety – the Clock’s Ticking
  4. Reinvestment risk – Got any ideas?
  5. Growth – the Enemy of Value Stocks
  6. When cheap isn’t cheap
  7. Hitting the target
  8. We liked it at $10, so we like it even more at $7
  9. Value Investing – Some Suggestions

Thanks for reading, I hope that you enjoyed this post.

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