Discounts and Relative Performance

By Rob Arnott

FEBRUARY 2009 Read Time: 10 min

The Fundamental Index™ advantage arises from breaking the link between prices and portfolio weights. Part of the historical advantage comes from the inherent value tilt associated with reweighting the growth stocks down to their economic scale and the value stocks up to their economic scale. But, a much larger contributor to the historical returns is that the Fundamental Index weight for a stock is very steady over time, providing an objective and rational anchor for rebalancing, for contratrading against the market’s constantly shifting expectations, fads, speculations, bubbles, and crashes.

Over the short term, however, the Fundamental Index strategies take on much greater exposure in volatile markets to companies whose prices have significantly underperformed their relative economic size. The reason is this rebalancing toward the Fundamental Index weight for each company. Shifting money to yesterday’s underperformers results in a portfolio that has a widening discount, as measured by common valuation measures, to the cap-weighted indexes. In this issue we explore the performance implications of the difference in relative valuation multiples.

The Fundamental Index methodology produces a model portfolio based on a company’s recent footprint in the macroeconomy. This is inherently backward-looking. By allocating to each stock in accordance with its financial scale, measured over the past five years, the methodology allocates weights that broadly reflect each company’s recent economic importance. The weights are determined by observable recent financial results. In contrast, capitalization-weighted indexes, such as the S&P 500 Index, represent Wall Street’s best guess as to the composition of tomorrow’s economy. In the cap-weighted methodology, price weights are driven by expectations. Naturally, Wall Street’s assignments of companies’ prospective values can and will shift much faster than the fundamental economic scale of the companies themselves.

The U.S. stock market at the turn of this century provides a classic example of overly optimistic future expectations dominating present economic fundamentals. Operating results in this period were having little impact on stock prices, particularly for those enterprises in so-called old economy industries, such as makers of industrial products. The information superhighway was the future, so the companies that would help build that highway, and ostensibly profit from it, were highly valued. Wild optimism about these companies’ roles in the new economy was the largest determinant of stock prices in 1999 and early 2000.

Reciprocally, today’s bleak expectations dominate any good news that may arise as the economy eventually turns. Pessimistic visions of tomorrow indicate we should expect a “basic needs economy,” with bare-bones credit markets and little in the way of consumer discretionary spending. Reflecting this dire outlook, the cap-weighted S&P 500 now has 41% allocated to the three economic sectors serving basic needs—namely, energy, health care, and consumer staples. This percentage is almost twice the size of the financials and consumer discretionary sectors, which were collectively slightly larger than the basic needs sectors a scant two years ago.

In unstable markets, when fast-changing expectations outpace the slower moving changes in company fundamentals, the Fundamental Index approach will deviate more sharply from capitalization weighting than in stable times. This divergence manifests itself in different valuation levels between indexes based on company fundamentals and cap-weighted indexes, as evidenced in Figure 2. Figure 2 depicts the relative price-to-book ratio (P/B) discount of the RAFI® US Large Company Index to the S&P 500 dating back to 1964. The peak in difference was reached in 1999 at 45%. As of December 31, 2008, the RAFI US Large had a P/B of 1.25 versus the P/B of 1.72 for the S&P 500, implying a discount of 27.4%. Only in three periods has the discount been larger than 27%—the Nifty Fifty era of the early 1970s, the biotechnology stock run-up in the early 1990s, and the tech-induced mania of 1999.

What do these relative valuation multiples imply about forward-looking relative return prospects for the Fundamental Index approach? We attempt to answer this question by looking at historical three-year excess returns of RAFI US Large over the S&P 500 , subsequent to periods of wide divergence in P/Bs. As Figure 3 shows, there is a link between P/Bs and subsequent returns. Wide discounts bode well for future Fundamental Index performance. From 1964–2008, the RAFI US Large achieves an average annualized excess return of 3.6% when its P/B is at a 27% discount or more to the S&P 500. Furthermore, it does so with consistency, as evidenced by its “batting average” winning 82% of the time and losing just 18% of the time. The next tier—discounts ranging from 20% to 27%—approaches the long-term historical average excess return for the Fundamental Index strategy of 2.0%, with a still-impressive 74% batting average. Discounts narrower than 20% lead to relative modest outperformance and only a 50/50 win rate.


Intuitively, we can interpret these results as follows. When expectations change rapidly, investors often let the pendulum swing too far. They extrapolate the good news (e.g., thinking the new economy growth stocks in 1999 would crowd out the old economy stocks for years to come) and the bad news (e.g., thinking the meltdown in financials and consumer discretionary companies in 2008 presage many years of depression). We don’t mean that the market routinely gets things wrong. In fact, recent research shows that growth stocks do indeed deliver better operating results and value stocks deliver poorer results, on average.1 Nevertheless, we have also discovered that although investors, on average, have been able to determine the future growers, they have done a terrible job of assigning the right price to that growth. Thus, future growth tends to be overpriced and future disappointment tends to be underpriced. We believe that expectations that are right in direction but overly optimistic are mispricings.

By design, the Fundamental Index approach avoids the return drag caused by capitalization weighting. It anchors a company’s weight on fundamental measures of company size and rebalances back to these measures annually. Rebalancing, whether among asset classes or within asset classes, is a proven investment tool that reduces risk and increases return over long periods. Over the short term, rebalancing proves frustrating because markets can take some time to revert to their mean returns. (Ask anyone who rebalanced into stocks at the end of 2000, 2001, and again in 2002!) But, reversion to the mean eventually takes place and rewards the disciplined investor who rebalances. Faith in rebalancing combined with a highly discounted current RAFI portfolio portends a bright horizon for those equity investors willing to stray from the cap-weighted indexing convention.

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1. Arnott, Li, and Sherrerd. 2009. “Clairvoyant Value and the Value Effect,” Journal of Portfolio Management, vol. 35, no. 3 (Spring).