Investment in variable income markets and the profitability of various management styles

Rafael Hurtado. Professor. IE Business School

5 November 2009

here are many different ways to invest and everyone can choose which one is best for them. They just need to know the differences between short-term and long-term investments, and between growth and value.

Many investors decide to buy shares or share indexes as a short-term investment. However, other investors, such as those who take out a pension scheme or buy variable-income assets with a view to leaving their wealth to their children or grandchildren, are making a much longer-term investment.

The following questions come into play with the latter type of investment. How much does variable income provide in the long term? Is the style of "value" more profitable than the style of "growth"? Should I invest in small companies despite their lack of liquidity?

Various academic studies have provided a response to all the above questions.

Investment in variable income compensates the risk that is assumed in the long term. Investment in variable income has historically produced a revaluation in real terms (higher than inflation) of around 5-6% for the immense majority of countries. The works by Dimson, Marsh and Staunton stand as references in this subject.

However, although most academic studies tend to use figures from long-term stock market revaluations of countries such as the United States, Japan, United Kingdom and even Spain, they ignore those of countries whose stock market disappeared on the back of one external cause or another, such as the case of Russia. Therefore, studies such as those by Dimson, Marsh and Staunton, which cover the period from the beginning of the 20th century, suffer from what is technically known as "survivorship bias", i.e. they only take into account the revaluation of the markets that have survived to present day.

Goetzmann and Jorion have also made interesting academic studies of the long-term profitability of stock market investments. Their most outstanding conclusions are that the American market offers an annual profitability above inflation of around 5%, which is an exception to the rule. According to these two professors, the average variable income market, bearing in mind those that have disappeared, has obtained a profitability of 1.5% above inflation in the long term.

The academic studies focus not only on analysing the past profitability of the markets, but also on finding out if there is any one style of management that has behaved better than others.

Various analyses performed by prestigious academic centres reveal great differences in the behaviour of different types of securities. Shares under the "value" style umbrella, i.e. those with low multiples, behave better than growth-type shares.

To determine whether a share is value or growth, the different studies usually analyse different ratios, such as the price-earnings ratio (P/E), the price-dividends ratio (P/D), the price-book value ratio (P/BV) and the price-cash flow ratio (P/CF). A share is considered as a value-type share when it has low ratios (especially the price-book value ratio, which is the most stable).

In addition, small enterprises have been more profitable than their large counterparts. Therefore, the investment style with higher returns is that of small enterprises under the value style umbrella.

With regard to the styles of listed companies and their stock market behaviour, the works by Fama and French are particularly relevant. In one of their recent publications (The Anatomy of Value and Growth Stock Returns), the two authors estimated the nominal returns of small value-type shares at an annual rate of 14.44% during the period 1927-2006, when the market returned an overall 9.83% Large growth-type shares performed at 9.18% during the same period, whereas the small growth-type shares returned 8.69%.

The reason why many studies reveal that small shares behave better than large shares would appear to be obvious. Small shares have an illiquidity premium.

However, the explanation of why value-type shares have behaved better than growth-type shares is more complex. Value-type shares, as has already been analysed, involve lower multiples and their volatility is historically better than growth-type shares and the rest of the market. Therefore, we can conclude that value-type shares have had less risk and more profitability, which undoubtedly poses a challenge for the theory of efficient markets.

To understand this anomaly, it is necessary to analyse concepts that are closely related to behavioural finance. When they buy shares, many investors prefer to buy good businesses at excellent prices than normal businesses at normal or low prices. Because they operate in sectors that are in fashion, investors are prepared to pay prices for growth-type shares that are not fully justified from an exclusively financial point of view. However, value-type shares usually operate in traditional sectors or sectors that are not included in the toing-and-froing of different trends.

Any short-term investment must take into account that variable income has provided long-term levels of profitability above inflation and above risk-free assets; however, owing to its volatility, during lengthy periods of time (20 years, for example), investors may suffer from capital losses. If an investor wishes to enter into long-term variable income, it is more recommendable to buy value-type shares, i.e. with low multiples, and avoid the companies and sectors that are in fashion, as occurred with the Internet companies during the financial bubble of ten years ago. Despite the fact that small firms have performed better than their larger counterparts, their inclusion in a portfolio must depend not only on their anticipated profitability, but also on their risk, since they have a greater lack of liquidity.


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