Saturday, March 7, 2009 3 comments

Value investing supposedly did ok in Japanese crash but not the Great Depression

I ran across an article by Brett Arends in The Wall Street Journal briefly mentioning some study that suggested that value investing would have done fine during the Japanese stock market meltdown (1990+) but not during the Great Depression:

Investors have been through this sort of meltdown twice before in the modern era: Wall Street during the 1930s, and Japan in the 1990s. What do they tell us to expect? James Montier, the great contrarian strategist at SG Securities, has run the numbers and they are fascinating.

In a nutshell: If we end up like Japan, value investors are going to make money. If we end up like the Great Depression, absolutely no stock market strategy is going to work for the next couple of years.

Take the second one first. From 1929 to 1932 everything collapsed. Low-cost "value" stocks did just as badly as everything else. Ironically, profits for some companies held up well. But it didn't help their stockholders. For three terrible years there was such massive "deleveraging" throughout the financial system that they all fell.

Intelligent Investor: Tempest-Tossed? Take Some ControlSunday Journal: Even 'Value' Investors Can't Beat this BearBut that wasn't the case in Japan. Sure, from 1990 to the present the overall market indices have plunged a long way. A simple index fund would have lost you, on average, about 4% a year. Fans of the index fund often subscribe to the "efficient market hypothesis," which says you can't beat the market. But nobody told those who followed "value" strategy in Japan in manner of Benjamin Graham and David Dodd, the authors of Security Analysis.

Mr. Montier of SG Securities found that a Japanese investor who stuck to a disciplined "value" strategy throughout the country's 18-year bear market actually made about 3% year. The main losses on the index came from the collapse in the financials and other fallen "growth" or "glamour" stocks. As long as you avoided those, you did OK.

Investors in the kind of absolute return fund that could buy value stocks and then "short", or bet against, so-called "growth" stocks did even better. Annualized returns from this strategy: 12% a year, even while the Nikkei plunged from 39000 to about 7200.

The fact that value investing does poorly during severe deflationary busts, such as 1929-1932, should not be surprising. I quoted Seth Klarman in a prior post where he suggests that deflation is the dagger to the heart of value investing. I also have mentioned that growth may outperform value during a deflationary bust The example I always like to think of is Coca-Cola, which actually did well during the Great Depression--note that Coca-Cola was a growth stock back then.)

The Japan example is interesting to me. I didn't know, at least according to the methodology that is quoted in this article, that strict value investing would have posted a positive 3% per year. That is quite impressive given the environment of Japan over the last 18 years. The key point of the Japan case is that one needs to avoid the overvalued sectors. This is actually not evident right away (one just needs to see how financials looked cheap two years ago but they clearly weren't.)

The author goes on to ponder whether we are are in an environment more like that of Japan in the 90's or the US in the 30's. My feeling is that we are nowhere near what USA was experiencing in the 30's. Whether you look at the economy (GDP growth, unemployment rate, industrial production (ISM), service production (ISM), etc) or businesses (corporate profits, debt, etc,) we are nowhere near the Great Depression. Instead, it seems, at least to me, that we are in an environment that will resemble Japan*. At least that's my macro view presently.

(* Even though I say we may end up like Japan, it will not be as bad for stock market investors. As pointed out several times before (including this Jeremy Grantham piece), the real estate bubble in Japan was far larger. Its stock market bubble was also far larger than in America. In contrast, most of the problem in America lies with the individual household rather than the corporate sector. Therefore, my guess is that the stock market will not perform as poorly as in Japan. Furthermore, as the American stock market declines more and more by the day, it will get to the end more quickly.)

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3 Response to Value investing supposedly did ok in Japanese crash but not the Great Depression

July 27, 2009 at 11:59 PM

"If we end up like the Great Depression, absolutely no stock market strategy is going to work for the next couple of years."

Long/short equity should actually do very well in a Great Depression environment.

True deep value investing did very well in the Great Depression - for example, Floyd Odlum ran up a $14 million cash stake into around $100 million from 1929 to 1934 by purchasing investment trusts and other stocks at 50%+ discounts to their net cash values, becoming one of the 10 richest in the USA in the process. By comparison the Dow lost about 75% over that period. So a value investor outperformed the market 28-fold in 5 years - this contradicts what Mr Montier and (to a lesser extent) Mr Klarman say.

Sivaram Velauthapillai
July 28, 2009 at 2:21 PM

I'm not sure about Floyd Odlum but will look him up. Based on my limited readings, my impression is that value still underperformed during the Great Depression.

In the past, I tried looking to see if I can find performance of value stocks vs growth stocks during the Great Depression but couldn't find any benchmark (I don't even think those terms were used, let alone indexed). If anyone knows of any source, let me know.

As for long-short funds and similar strategies, I agree wtih you that they will outperform long-only during severe bear markets. But I'm not sure how well they will do over the full cycle. The Great Depression was sort of special in that it was a rapid 4-year collapse. But if we end up like Japan, I am not sure how well the long-short funds will do. I'll be writing a brief post on this soon...

Sivaram Velauthapillai
July 28, 2009 at 2:34 PM

Re-reading the quoted text in the original post, there is something that stands out to me.

James Montier says that disciplined value investors in Japan would have done ok but my guess--it's only a guess--is that value investors may have been exposed to financials. I am not familiar with how Japan was at that time but if financials were anything like the American financials of a few years ago (i.e. looks cheap on fundamental measures; high ROE; many years of high profits; etc) then valeu investors may have been vulnerable. A lot of value investors got decimated in the current crash because a company like Freddie Mac (Bill Miller) or Washington Mutual (Bill Nygren) or Wells Fargo (Warren Buffett) looked good on fundamental measures but they were actually booking fictitious profits and were over-leveraged. Even Warren Buffett missed out on Wells Fargo, which seems to have very high leverage if you just look at tangible capital (Buffett is lucky that the US govt was lenient and didn't force more capital ot be injected into it.)

One of the problems with studies like these is that what seems obvious in hindsight is rarely so if you were investing at that time. For instance, it almost always turns out to be profitable to short "growth" stocks during market crashes. But it's hard to say what is a growth stock, except in hindsight. For instance, many commodity business--say fertilizer companies or uranium mining companies--were posting spectacular growth a few years ago but how many would have shorted them because they were growth 3 or 4 years ago?

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