The Brandes Institute (Institute), part of the fund manager Brandes Investment Partners, whom I greatly admire, in September 2009 updated their study on the performance of Glamour vs Value stocks.
The study is titled: Value vs. Glamour Revisited ? Historical P/B Ratio Disparities and Subsequent Value Stock Out-performance. Where Glamour stocks are defined as stocks with high price to book (?P/B?) values and Value stocks as having low price to book ratios.
In a previous study called Value vs. Glamour: A Global Phenomenon (September 2008) the Institute found that between 1968 and 2008 value stocks consistently outperformed glamour stocks worldwide.
What makes this study remarkable is that they looked at the difference in valuation between value and glamour stocks by dividing the glamour stock P/B ratio by the value stock P/B ratio and calculated the five year subsequent value out-performance against glamour.
To visualise it more easily they looked at the ratio: (Glamour P/B) / (Value P/B)
Value delivered the largest outperformance
They found that after the ratio had peaked, i.e. the valuation difference was largest, value stocks delivered meaningful out-performance over the next 5 years.
The most extreme valuation difference between glamour and value stocks occurred in February 2000 when glamour stocks were 81.1 times more expensive than value stocks. In the five year period from February 2000 value stocks outperformed glamour stocks by 50.6% annualised. And that over five years!
So, from the first study we know that value outperforms glamour but the second study shows that when the valuation difference gets larger the out-performance increases substantially.
So what was the situation at the March 2009 market low point?
In February 2009 the valuation difference climbed to 20.0, the last time it was this high was January 2001. By April 30, 2009 the ration declined to 15.4 just slightly above the 1968 to 2008 average of 12.3.
What does this mean for you and me?
First of all, buying undervalued shares work as the first study has shown. And this using only one simple ratio such as price to book, ignoring other important factors such as debt levels, return on assets and capital.
Secondly the worst time to change your strategy is when the valuation differences are at their greatest. As that is exactly the point when the greatest returns can be made, if you stick to your strategy.
This is also exactly that a lot of investors did not do during the internet bubble, value investors changed their strategy, started buying technology shares, and lost their shirts shortly thereafter.
You have to know what works
Thus, if like me you have a strategy that you know works and that has been tested over long periods of time you have to keep on reminding yourself why you follow the strategy, so much so that you will not abandon the strategy when it has substantially underperformed the market and all may seem lost.
Because it is exactly from this point forward that you will make your largest gains.
