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Crystal Clear

Imagine you had a crystal ball and could see the future of the world’s many stock markets over the next twenty years. Imagine you could see the eventual returns of the roughly 13,000 globally-traded public companies across 40 different countries – and the crystal ball could clearly identify for you which stocks would yield higher long term returns than others.

If you wanted market-beating returns in the long run, would you use that information to build out your investments in the stock market? You probably would. And since you would know which stocks and stocks asset classes will produce the highest eventual returns, you’d probably be less reactive to the ups and downs of the markets year to year: after all, you’d have the advance knowledge that in the long run, your stock market holdings will have earned the highest available returns…which would be comforting one year to the next, right?

Unfortunately, none of us have a crystal ball to look into. We don’t know what the future holds for the world’s stock markets, and that makes us uncomfortable as investors. However, while we can’t see into the future, we are able to look back over years and years of stock and bond market data – and using such data, determine which kinds of stocks and stock exposures (factors) have historically created higher returns (premiums) in the stock market.

Let’s look at these stock exposures/factors one by one. First, investors in the stock market expect to be compensated more for the ups and downs (volatility) of their stock market investments over more stable alternative investments like bonds, and this additional amount of return over bonds is called the “market premium.” Without this premium, investors would not have the financial incentive to choose stocks over bonds. The additional return – the “market premium” – we believe, is the entire reason investors put their money in the stock market in the first place.

Three other kinds of “premiums” exist. While stocks have generally yielded higher returns than bonds, some stocks with certain characteristics have historically produced higher returns than other stocks. Which stocks have historically paid a higher return?

  • Small cap stocks generally outperform large cap stocks: the stocks of relatively smaller companies are deemed riskier than their blue-chip, established counterparts. Thus, investors have come to expect higher returns over time for being invested in smaller, less established companies than investments in bigger, lower-risk companies. This is often referred to as the “size premium,” which is simply the difference in long term returns of smaller cap companies over large cap companies.
  • Value stocks generally outperform growth stocks: again, value stocks are deemed riskier in nature than growth stocks, and investors expect to be paid more for the additional perceived risk. Value stocks can be defined in several ways, but generally have lower share price-to-book value ratios than growth stocks. While value stocks do not always beat growth stocks, value stocks over a certain period of time have paid higher returns to investors than growth stocks have. This additional level of return is referred to as the “value premium.”
  • Highly profitable companies tend to perform better than the stocks of less profitable companies: Financially healthy companies generally produce profits, and profits drive stock prices. The better the profits, generally the better the stock price behavior. The returns of more profitable companies over less profitable companies is called the “profitability premium.”

While we believe that we can generally expect positive market, size, value, and profitability premiums over time (ie. ten years and longer), we know from history that these four premiums are unpredictable as to when they occur, and can sometimes be negative for long periods. This can frustrate investors, causing them to change their portfolios and allocations – often at the wrong time. An example is the recent years of growth stock outperformance over the returns of value stocks, and the simultaneous occurrence of small stocks underperforming large cap stocks. Of the four market factors we’ve highlighted in this paper as return-enhancing factors, two have actually been negative in recent years. This leads investors to wonder “is it different this time? Should we make portfolio changes?”  

History may be indicative of the answer to these kinds of questions. In Exhibit 1 below (US equities), we explore each of the four factors individually , and we can see how often they’ve been negative. Not only can they be negative, but they can continue being negative for some time. When premiums turn negative, we do not believe that it necessarily means you should make changes or assume that positive premiums will never occur again.

Exhibit 1*
Percentage of Rolling 1-, 5-, and 10-Year Periods with Negative Returns

US equity market through December 31, 2018

In Exhibit 2 below, we can see how often one, two, three, or all four of the premiums were negative in combination (ie. more than one premium was negative) over rolling 10-year periods. In this exhibit we can see that – of the four historical premiums (market, size, value, profitability) – at least one of them disappointed in almost half of the rolling 10-year periods (49.4% of the time). That’s a high percentage, and shows that a negative premium in at least one of the four categories of premium is almost to be expected. What is more interesting is how rare it has been that two negative premiums occurred at the same time, as is the current case with small cap stocks trailing large caps, and value stocks continuing to trail growth stocks.

Exhibit 2*
Number and Percentage of Rolling 10-Year Periods with Negative Premiums

US equity market, July 1963-December 2018

So if a negative return premium is common, and sometimes – albeit rarely – can occur in tandem with another negative premium, then why invest with exposures to these factors at all? What’s in it for the investor who tries to capture all four premiums, takes the long view, and rides out the times of underperformance when a premium is negative?

Exhibit 3 shows the impact of positive premiums. Exhibit 3* identifies the rolling 10-year periods when a premium was negative – and then observe how the premium behaved over the following 10 years. (Profitability is excluded because there were only two data points). As you can see below, negative premiums tend to be followed by periods of exceptional outperformance (positive premiums). Based on this data, outperformance over extended periods historically has more than made up for the periods of underperformance, leading to overall higher long-term returns. Those differences in returns are what creates market-beating performance.

Exhibit 3*
Subsequent Performance of 10-Year Premiums Following a Negative 10-Year Premium

June 1927-December 2018

In conclusion, based on the data above, we believe that if you want to get better returns than the market, you must invest your portfolio differently than the market. Theoretical and empirical studies have shown that four stock market factors – market, size, value, and profitability – have the potential to increase portfolio returns in the long run. Yet therein lies the challenge: successful capture of all four premiums requires patience… something most investors don’t have enough of.

*Source: Dimensional Fund Advisors LP, “Perspective on Premiums”, pages 2 and 3.


All investment strategies and investments involve risk of loss. Nothing contained in this letter should be construed as investment advice. Any reference to an investment’s past or potential performance is not, and should not be construed as, a recommendation or as a guarantee of any specific outcome or profit.

This report is distributed for general informational and educational purposes only and is not intended to constitute legal, tax, accounting or investment advice. Any opinions expressed herein are CPWM’s current opinions and do not necessarily reflect the opinions of any of its affiliates. Furthermore, all opinions are current only as of the date hereof and are subject to change without notice. CPWM does not have any obligation to provide revised opinions in the event of changed circumstances.

CPWM may gather information and data contained herein from third parties that it deems to be reliable, however, no guarantee, representation or warranty is given by CPWM regarding the accuracy, completeness or validity of any information that are sourced from third parties. All opinions of third parties included in this presentation are those of such third parties and do not necessarily reflect the opinion of CPWM, it’s employee’s or affiliates. Any ideas or strategies discussed herein should not be undertaken by any individual without prior consultation with a financial professional for the purpose of assessing whether the ideas or strategies that are discussed are suitable to you based on your own personal financial objectives, needs and risk tolerance. CPWM expressly disclaims any liability or loss incurred by any person who acts on the information, ideas or strategies discussed herein. Individual investor performance may vary. All investing involves a degree of risk, including possible loss of all amounts invested.  

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