Investing in an Unprecedented Environment
The first quarter of 2020 can be delineated as a tale of two very different periods. The first of these periods lasted approximately through late-February and represented a continuation of the environment seen in much of the last calendar year. These recent quarters featured an increasing market focus on business fundamentals. This period gave way to extraordinary levels of volatility and a sweeping market crash as it became increasingly clear that the outbreak of COVID-19 was a headwind not merely isolated to China. This quarter will be looked back on as a memorable period of market history.
There was a range of prominent market effects during this quarter in which investor sentiment quickly cycled through a range from incredulity to fear and eventually to a level of panic that has not been seen in over a decade. Perhaps the most notable effect seen during the quarter was the acute underperformance of virtually every variation of valuation factor. This was particularly strong with small caps.
The chart below demonstrates this by displaying every quarter since 2008 for the Russell 2000 small cap index, where the current fiscal year (FY1) earnings/price (E/P) factor underperformed. Specifically, the chart shows every quarter where the returns of the cheapest three deciles of the FY1 E/P factor underperformed the factor average for the entire Russell 2000. FY1 E/P is used for simplicity, given it is generally representative of the broader set of valuation factors.
Virtually all valuation factors demonstrated the same trends. These factor deciles are sector neutral, meaning that each decile is comprised of the same sector weights as the overall Russell 2000 to remove any potential sector biases in the data.
Source: Hillcrest Asset Management
The chart above provides a useful frame of reference for understanding the magnitude of the recent headwinds faced by valuation factors. The data exhibits that the past quarter was the single worst period for the FY1 E/P factor since the beginning of 2008. Furthermore, the data also shows that the fourth quarter of 2008, another memorable period in market history, is the only other quarter where the factor has underperformed by a comparable degree. The underperformance of FY1 E/P and similar valuation factors in each of these periods is not an arbitrary casualty of the swift market crashes that occurred in these quarters.
Instead, the especially severe underperformance of valuation factors in these periods reflects the behavioral tendency of investors to haphazardly stampede to areas of perceived safety at all costs during periods of intense panic. In such periods the prevailing investor psyche becomes particularly myopic and bifurcated as valuations are primarily seen as a barometer of risk, and many companies with attractive valuation characteristics are unjustifiably shunned.
This effect is not surprising given that investing in companies with attractive valuation characteristics requires courage from the average investor even during sanguine periods despite the abundance of objective evidence that shows such companies tend to outperform over time. This natural aversion of the average investor is the fundamental reason why valuation factors can outperform over time in the first place.
Beyond the quantitative similarities exhibited between the first quarter of 2020 and the fourth quarter of 2008, the qualitative ferocity of the market panic seen in March resembles late-2008 more so than any other period in the past decade. However, while the recent period is similar to the mood in late-2008 to a degree, there was extraordinary opportunity created by the extreme market behavior in this period.
The chart below illustrates this by displaying the relative returns of the FY1 E/P factor for numerous measurement periods that begin only shortly after the factor recorded the outsized period of underperformance in the fourth quarter of 2008. Like the previous chart, this data measures the relative return for the factor as the best (cheapest) three deciles of the FY1 E/P factor versus the factor average for the Russell 2000 index. Abstaining from market fear and focusing on valuations, despite the previous poor performance, generated a material degree of durable outperformance. To be sure, much remains unknown about the current environment and how the specific effects of the pandemic will unfold and ripple through businesses and the economy.
However, it is meaningful that the aversion to companies with attractive valuation characteristics proved unfounded even amidst the daunting uncertainty and headwinds brought by the environment in 2008/2009.
Source: Hillcrest Asset Management
The unprecedented nature of the pandemic and its effect on the business and market environment has been routinely emphasized by commentators, journalists, and market participants alike. The circumstances of the current environment are unique, and no one alive has invested through an environment with these variables. However, while the specific variables and catalysts in the current market environment are indeed unprecedented, the emotions and behavior exhibited by investors through this period are not.
Investor behavior is unchanging throughout time, given that common behavioral tendencies are inseparable from human cognition itself. In other words, even though the specific situational circumstances can be vastly different between Q1 2020 and Q4 2008, as well as other notable periods, the underlying investor behavior at play in each of these periods is more similar than different. Therefore, because the behavioral tendencies exhibited by investors are ubiquitous across time, these biases and heuristics lead to observable repeated patterns in investor actions, such as the previously noted effects seen in value factors.
As we can see, the recent market downturn has hurt the prices of attractively priced small cap stocks and created a great buying opportunity. Small cap stocks have declined more than large cap stocks over this period with cheaper small stocks being hit the worst. Good behavioralists ignore recent events and look at history. In the 2008 downturn, the cheapest 30% of small cap stocks outperformed the Russell 2000 by over 5% annually for the next five years! If this crisis is anything like 2008, small value stocks are where you should be invested as the returns could be significant.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.