Rob Arnott’s tips for good value hunting

Trading against the most extreme bets into cheap inflation protection is rewarded, though it can take time

by Rob Arnott, Founder and chairman of Research Affiliates and a portfolio manager with bond investor PIMCO, via ProjectM Online

But the fear is hardly justified as companies rarely inflict a permanent loss of capital. Let’s assume a permanent capital loss is represented by a 90% stock price decline in three years or less, with no recovery in the following three years. Based on the annual returns of all individual stocks of the Russell 1000 Index from 1975 to 2015, only about 5% would be deemed value traps at any given time. They are rare events for stocks; for broad asset classes they are almost non-existent.

Asset classes representing a broad group of securities are inherently diversified. They may get cheap, then cheaper and finally cheaper still, but collectively, they don’t fall to zero, as individual stocks might. Of course, there will undoubtedly be value traps across multiple securities, but would an entire asset class vanish? Would all emerging market equities or all commodities concurrently go to zero? Not likely. In entrepreneurial capitalism, when old companies fade from view, newer and faster growing companies take their spot, eventually gaining a share in the economy.

Investors know and viscerally feel the pain associated with an uncharacteristic tumult in value, as growth has emerged atop the leaderboard in recent years. Although we’ve begun to see some reprieve, particularly across US small value stocks and emerging value stocks, the global rout in value since 2013 (and off-and-on since 2007) weighs on investors’ memories. In these trying times, it becomes tempting to question the long-term proposition of value investing.

Yet here are a few basic truths to strengthen investors’ conviction in a value-oriented, long-term and contrarian philosophy: firstly, value traps in individual stocks are rare events and rarer still in asset classes; secondly, mean reversion rewards the patient, long-term investor; and finally, history has demonstrated time and again that markets are driven by a quest for fair value.

Contra-trading against the market’s most extreme bets is eventually rewarded, though it can take time.

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