Can you beat most index fund investors…with index funds?
I’ll share a winning strategy that will take less than one hour a year. You won’t have to follow the stock market, and this method will thump the returns of most professional investors after fees. It might even beat most index fund investors.
Let’s start with index funds that focus on value stocks, the ugly ducklings of the investment world. Value stocks are cheap, relative to cash-flow, book value, and business earnings. In other words, they’re beaten-down stocks that nobody really wants, and their names certainly don’t get whispered around the water cooler at work. But they’re one of the best ways to invest your money (ask Warren Buffett).
Over time, value stocks beat high-growth stocks. That might sound like a contradiction, as growth stocks are stocks with fast-growing corporate earnings. They include darlings such as Apple, Amazon, Alphabet (Google), Netflix, and Tesla. But over long-term periods, ugly duckling value stocks deliver swan-like performances, typically putting growth stocks to shame.
Why value stocks prove to be long-term champs
According to portfoliovisualizer.com, large U.S. growth stocks averaged a compound annual return of 9.93% between January 1972 and November 2018. That would have turned a $10,000 investment into $841,620.
But large U.S. value stocks gave growth stocks a beating over that same time period, averaging a compound annual return of 11.24%. With value stocks that $10,000 investment morphed into $1,470,281.
When comparing medium-sized and small-sized stocks over the past 46 years, value stocks won again. Mid-sized growth stocks averaged a compound annual return of 10.11%; mid-sized value stocks averaged a compound annual return of 12.95%.
The gap is even wider when comparing smaller stocks. Between January 1972 and November 2018, small-cap growth stocks averaged 9.81%; small-cap value stocks averaged a compound annual return of 14.03%.
Value stocks don’t beat growth stocks every year. Nor do they win every decade. But as you can see in the table below, even with a few lost battles along the way they ultimately win the war and still represent some of the best stocks to buy today.
| Ten-Year Periods | Compound Annual Returns: Growth Stocks | Compound Annual Returns: Value Stocks |
|---|---|---|
| 1972-1982 | 7.59% | 14.52% |
| 1983-1993 | 13.56% | 17.24% |
| 1994-2004 | 10.85% | 13.01% |
| 2005-2015 | 7.27% | 8.06% |
| 1972-2015 | 9.99% | 12.95% |
Don’t get sucked into a growth stock trap
Investors typically peg high hopes on growth stocks, which pushes their prices up, and can swell their PE (Price-to-Earnings) ratios. For example, assume a company’s stock trades at $10 a share and that 100 shares exist. Such a company would be worth $1000, if you bought the entire business. If the company sold enough merchandise to earn $100 a year in profits, the company would have a PE ratio of ten times earnings. In other words, the company’s total price (if you bought the entire company) would be ten times higher than the company’s annual profits. In terms of real-world examples, Netflix has a PE ratio that’s almost 96 times earnings. Google (Alphabet) has a PE ratio of almost 39 times earnings. But when PE ratios start to swell, poor performance often follows.
Fewer people pin their hopes on cheap value stocks, but these under-the-radar equities are full of surprises, often turning out higher dividend yields. When such dividends are reinvested, they boost overall returns. Beaten-down value stocks also come alive when people recognize they’re bargains.
Growth stocks may have recently outperformed value, but that’s exactly why value might be headed for a win. Over the five-year period ending October 31, 2018, the iShares Canadian Growth Index (XCG) averaged a compound annual return of 6.50%. That beat the iShares Canadian Value Index (XCV), which earned a compound annual return of just 4.58% over the same time period. Vanguard’s U.S. Growth Stock ETF (VUG) beat its value counterpart too. Over the same five-year period, the growth stock index averaged a compound annual return of 12.08% (measured in USD). That beat Vanguard’s U.S. Value Stock ETF (VTV). It averaged a compound annual return of 10.28%.
U.S. growth stocks also won over the past ten years. They averaged a compound annual return of 14.57%. U.S. value stocks lagged, averaging 12.07%. As a result, compared to growth stocks, value stocks might be cheaper today than they have ever been before.
Value stocks offer the best bargain in years
Historically, value stocks are usually one-third cheaper than growth stocks. But in 2017, after a high growth stock run-up, Columbia finance professor Kent Daniel said value stocks were 50% cheaper than the average growth stock. Today, that gap is even wider. That’s why value might be the best stock to buy this year.
We’ve seen such price gaps before. In the late 1990s, growth stocks were expensive, relative to value stocks. Between 1995 and 1999, U.S. growth stocks beat value stocks by more than 5.5% per year. But over the following five years (2000-2005) value stocks trounced growth stocks by more than 8.5% per year.
I’m not saying value will beat growth this year or next. But over the next ten years, the odds of value winning are heavily in favour.
Maintain a diversified portfolio that includes American, developed international and emerging market shares. And don’t be afraid to embrace what’s cheap.
International stocks might also be ready to fly
This leaves a second ugly duckling that might also be poised to thrive: international stocks, not including U.S. shares. True, American stocks have thumped international stocks over the past 1, 3, 5, 10, and 15-year periods.
U.S. stocks have thumped international stocks
| Annual Performances | 1-Year | 3-Year | 5-Year | 10-Year | 15-Year |
|---|---|---|---|---|---|
| U.S. Stocks | 5.46% | 11.23% | 10.31% | 14.35% | 8.89% |
| International Stocks | -8.21% | 5.44% | 2.17% | 7.69% | 5.98% |
Source: Vanguard USA, using time periods ending November 29, 2018 (measured in USD)
But U.S. stocks are now expensive. Robert J. Shiller, Nobel Prize winner in Economic Sciences and a Yale University professor, founded something called the CAPE ratio (cyclically-adjusted price-to-earnings ratio). The CAPE ratio determines whether stocks are cheap or expensive, and it’s stricter than a standard price-to-earnings ratio because it doesn’t use a previous year’s business earnings as a measurement. Instead, it averages inflation-adjusted earnings over a ten-year period.
Shiller examined a variety of stock markets. He found that when stocks trade well above their historical average CAPE levels, they usually stumble in the decade ahead. However, when they trade below their historical-average CAPE levels, a strong decade usually follows.
American stocks have done well over the past ten years. Will American equity be the best stock to buy this year? Some precarious metrics cast doubt on this idea: Based on Shiller’s CAPE ratio, they’re now in the nosebleed zone. On November 30, 2018, U.S. stocks traded at a CAPE ratio of 30.74 times earnings. That’s almost double the U.S. stock market’s historical average.
When U.S. stocks are this expensive, disappointment follows
Based on CAPE ratios, the U.S. market has only been this high twice before: in 1929, right before the market crash, and in 2000, right before the “lost decade.” During that decade (2000-2010) U.S. stocks averaged a compound annual return of just 1.2%. That didn’t match inflation. In other words, the rising price of a box of Corn Flakes beat U.S. stocks for a decade.
Compared to U.S. stocks, international stocks are cheap. But they’re currently shunned by many because they haven’t performed as well as of late. Over the next decade, avoiding such stocks could be a huge mistake.
On October 31, 2018, Star Capital calculated the CAPE ratio for European stocks at 17.7 times earnings. That’s within Europe’s historical average range. Emerging market stocks traded at a CAPE ratio of 14.6 times earnings. That’s below their historical average range. Canadian stocks traded at a CAPE ratio of 20.1 times earnings. Once again, that isn’t far from the Canadian market average.
Diversification beats speculation
If your portfolio has a growth-stock bias, or if you’ve shunned international shares, it’s time to switch things up and stack the odds in your favour. Vanguard Canada’s Global Value Factor ETF (VVL) is diversified well, and includes 1,144 global stocks, comprising U.S. and international developed market shares. Investors could also buy the iShares Canadian Value Index (XCV) for their Canadian stock exposure, and should add bonds to round out their portfolios. The higher the bond allocation, the lower the short-term risk; but high bond allocations also limit future growth.
You can tweak your existing portfolio (or start a new one) to mimic the index/ETF/bond allocation levels in the table below, or some approximation of them. If you want to cut down on costs, consider circumventing a traditional broker and instead using an online broker with low management fees. Questrade is a good example, as it charges only $4.95–$9.95 per trade, with ETFs free to buy.
Model portfolios with a global value tilt
| Conservative Allocation | Balanced Allocation | Assertive Allocation | |
|---|---|---|---|
| iShares Canadian Value Index (XCV) | 15% | 25% | 35% |
| Vanguard Global Value Factor ETF (VVL) | 20% | 30% | 35% |
| Vanguard FTSE Emerging Markets All-Cap Index ETF (VEE) | 5% | 5% | 10% |
| Vanguard Canadian Aggregate Bond Index ETF (VAB) | 60% | 40% | 20% |
If you’re not comfortable designing and rebalancing your own portfolio you might elect to invest in a robo-advisor instead, which matches you to pre-built portfolios. But the same approach applies: Ask to be matched to a portfolio of ETFs with an emphasis on value stocks, emerging market stocks, and European stocks. Then keep adding money, rebalance once a year (or have your financial advisors rebalance for you), and be confident in your strategy.
