A Winning Investment Strategy (Historically)

The S&P Down Jones Indices committee made headlines when they announced that they were going to add Tesla to the S&P 500 last December.  The high flying growth stock price surged after the announcement, in anticipation of the forced purchases that index funds would need to make once the stock was officially added to the index.  

To make room for Tesla, a company needed to be dropped from the Index.  Apartment Investment and Management, or Aimco, was the stock that was dropped from the S&P 500 index.  Predictably, shares of Aimco prices dropped significantly following the announcement that they were going to be dropped from the Index, in anticipation of the index funds forced sale of their shares.

At the time, Robert Arnott, Chairman of Research Affiliates, predicted that Tesla would trail the return of the S&P 500 Index over the next year.  He also predicted that Aimco would beat the return of the S&P 500 over the next year.  The reason?  The run up in Tesla's stock price as investors anticipated its addition to the S&P 500 made it highly over-valued relative to the companies fundamentals and growth prospects going forward.  Aimco, on the other hand, did not necessarily deserve a lower valuation strictly due to its deletion from the index.

So far, his prediction has been spot on.  Since its addition to the S&P 500 Tesla's stock price has been flat, badly underperforming the S&P 500 which has returned about 17% over the same timeframe.  Aimco, on the other hand, has returned 44% since its deletion from the index.

So, is this a special situation that is specific to Aimco and Tesla?  It turns out that its not.

Jeremy Seigel, in his book "Stocks for the Long Run", looked at the performance of the original S&P 500 firms relative to the more than 1000 stocks that have been added to the index since its inception in 1957.  He found that if an investor had simply bought and held their original 500 stocks, never sold, and never bought any of the over 1000 additions, they would have outperformed the index by over 1% per year.  

He describes how, during the energy crisis in the early 1980's, 12 of the 13 energy stocks that were added to the S&P 500 Index during the late 1970's and early 1980's did not subsequently match the performance of the S&P 500 Index.  In the late 1990's, large telecommunications firms such as WorldCom, Global Crossing, and Quest Communications were added to the index and subsequently collapsed.  Of all of the 10 industrial sectors in the S&P 500, only the consumer discretionary sector has added firms that have outperformed the original firms put into the index.  This sector was dominated by auto manufacturers (GM, Chrysler, and Ford) and their suppliers (Firestone and Goodyear), and large retailers, such as JC Penney and Woolworth's.

"Why did this happen?  How could the new companies that fueled our economic growth and made America the preeminent economy in the world underperform the older firms?  The answer is straightforward.  Although the earnings and sales of many of the new firms grew faster than those of the older firms, the price that investors paid for these stocks was simply too high to generate good returns."

So what is the key takeaway?

While it may seem like the high-flying growth stocks are the best investment going forward, historically this is not the case.  It's not that these aren't great companies with great prospects.  It is simply because these stocks are priced too high.  When a stock is priced high relative to its fundamentals (ie. sales, book value, profits, cash flow), that indicates that a lot of optimism is already baked into the price.  On the other hand, value stocks are low-priced stocks relative to their fundamentals.  They are previous high-flyers or companies that have too much pessimism baked into their price. 

While they go unloved by investors today, as a group value stocks tend to outperform in the long run.

Photo by Mathieu Stern on Unsplash