Style over Stocks

[The following is from p.164-167 of The Guru Investors by John Reese and Jack M Forehand.]

As we noted earlier, Fisher’s investing approach has evolved in many ways since the original publication of Super Stocks. In the 1990s, for example, he began to focus more and more on the importance of investment style. Investors, he said, need to focus on style and to rotate their investment holdings to match the popular style of the time.

One interesting example of what Fisher meant by “style” involves his study of stock returns between January 1976 and June 1995. In this study, he broke stocks down into six styles: big-cap value, midcap value, small-cap value, big-cap growth, midcap growth, and small-cap growth. What he found was that these styles went in and out of favor periodically. From January 1976 to September 1978, for example, small cap value was the leading style, producing an annualized return of 42.69 percent. This beat the loser, big growth, by 37.84 percent. The spread of the best four styles over the worst two was big — 23.25 percent — and the four best styles outperformed the S & P 500 by 23.41 percent.

The bottom line for the entire period studied (January 1976 to June 1995) was:

The annualized return for the best four styles at a given time 17.79%

Annualized market return (Wilshire 5000) 14.64%

Premium of best four styles over the market 3.15%

For Fisher, this was evidence that style selection was a crucial part of achieving excess returns in the market. If you could figure out when certain styles were going to be in favor, you could pick from a wide swath of stocks in that style and do well. To decide which style to pick, he would use certain economic indicators, such as the yield curve (which measures the relationship between shorter- and longer-term interest rates) and how the U.S. gross domestic product (GDP) compared to overseas GDP. Back then, he advocated focusing on what he believed the best four styles at a given time were, and avoiding the worst two. Focusing your investments only on what you believe is the best style at a given time could net you even better returns, but you risked losing a bunch if you picked the wrong style.

As Fisher focused more and more on style, he scrapped the PSR strategy he had detailed in Super Stocks. The reason? He believed that once the masses learned about it, the ratio had become priced into the market. Essentially, more people were focusing on low-PSR stocks, driving their prices higher and limiting the gains you could get from buying them. (We’ll address this and its impact on our model in a bit.)

Today, Fisher remains focused very much on style, so much so that he says only about 10 percent of his strategy involves actual stock selection. He writes in “The Only Three Questions That Count” that about 70 percent of it involves assessing various economic, political, and sentiment drivers to determine asset allocation — that is, how to divvy up investment dollars among stocks, bonds, and cash. Another 20 percent is “sub-asset allocation,” which involves deciding which countries, which sectors, which types of market capitalizations, and which styles (value or growth) to invest in. Only after he’s determined how much of his portfolio to put in stocks and which categories of stocks he’s interested in does he start looking at individual stocks. From there, he says, he goes category by category (one category might be “U.S. small-cap value industrials”, for example), and picks a few stocks from each.

How does he pick those stocks? Part of it is fundamentals (in one example he mentions in “Three Questions,” he even notes that a stock he liked was selling at a low price for its revenues — essentially meaning its PSR was low). But a big part of it is non-quantitative, as is the way he decides his asset allocation and sub-asset allocation. One of the key points in “Three Questions” is that, according to Fisher, “You can’t make market bets and win long term unless you know something others don’t.” It’s the same concept behind his reason for ditching his low - PSR approach: Once the masses are aware of an investment 166 the growth legends strategy, it gets priced into the market. That’s why one of the three questions the book’s title refers to is “What Can You Fathom That Others Find Unfathomable?”

One example Fisher gives of something he can fathom but most investors can’t is the “presidential term cycle.” Part of this phenomenon is that, historically, stock returns are much better in the third and fourth year of a president’s term than they are in the first two years. Fisher surmises that investors are more hesitant in the first part of the term because that’s when big changes can occur as the president begins to put his or her agenda into action. In particular, one thing that can occur is the redistribution of wealth through tax and other legislative changes, something that makes Wall Street very cautious. By the third and fourth years, however, the president has settled in and controversial legislation is unlikely because he or she is trying to get reelected or is simply tired and hanging on as their term winds down. Investors have more of an idea what they can expect, so they’re more likely to be bullish, the theory goes.

Fisher is also a big proponent of looking at global economic indicators — not just those that reflect conditions in the United States. He uses the global yield curve (the spread between shorter - and longer - term interest rates) as a way to discern whether to focus on growth or value stocks, for example. “Simply put, the global yield curve tells you when to switch from value to growth and back,” he writes. “After it has gone completely flat, you head into a period of growth stock dominance. After it gets very steep, you switch into value stock dominance. After it flattens, it’s time to tilt to growth again.” Fisher focuses on the global yield curve rather than the U.S. yield curve because, “If one country’s yield curve inverts while the global yield curve remains positive, there are still opportunities for businesses, institutions, private clients, and so on to continue doing business globally.”

Fisher also considers factors such as the global gross domestic product and global inflation. This global focus, particularly the global yield curve information, is another example of how Fisher takes advantage of knowing something that most other investors don’t know. (Be aware that Fisher doesn’t base his approach on just one thing that he can fathom but others can’t — “Never assume you have found the one silver bullet,” he writes.)

The presidential cycle, global yield curve, and other atypical factors Fisher uses today to guide his investment approach are quite interesting, but, to Fisher, they’ re not carved in stone. “The advantages I showed you will all fade away one day” as they become known and priced into the market, he writes. That’s why it’s critical, he says, to continue to try to fathom what other find unfathomable. “Winning at investing requires constant innovation and constant testing,” he says. Put another way, you have to be willing to go against the Wall Street grain to win in the stock market. That same rebelliousness that led Fisher to focus on the PSR years ago is still there; it’s just in a different form today — and it could be in a different form tomorrow, next month, or next year, depending on what happens in the investing world.