Introduction: As steadfast believers in value investing, Hoover Capital Management (HCM) has always been intrigued by the interplay between base rates and case rates in both the market and nature.
Before delving deeper, let’s define these crucial terms:
Base Rate: In investing, as in assessing natural phenomena, the base rate refers to the underlying frequency of an event in a broad context. It’s the general occurrence rate that we can expect under normal conditions. In the context of value investing, this relates to the consistent, long-term performance trends observed over time.
Case Rate: Contrasting with the base rate, the case rate focuses on specific, often sensational instances. In financial markets, this can be compared to sudden surges or drops in stock prices or market segments, akin to rare but high-impact events in nature.
These concepts, much like the phenomena observed in the natural world, offer HCM practical insights for navigating the often-turbulent waters of investing. For example, while the annual chance of a shark attack is only about 1 in 11.5 million, it often garners disproportionate attention, similar to how sensational growth stock stories can overshadow solid value investing principles. The allure of growth investing (the case rate) can be compelling, especially during high-flying periods, but HCM views these times with the same cautious scrutiny one would reserve for rare, yet often overstated, natural events.
Section 1: The Steady Hand of the Base Rate – Value Investing Value investing represents the base rate in investing, akin to the frequency of shark attacks in nature. Despite their sensational portrayal in the media, the likelihood of an individual being bitten by a shark is incredibly low, estimated at 1 in 11.5 million. This low base rate of incidents reflects the true risk, much like how value investing operates on the principle of looking at the long game, focusing on stocks undervalued relative to their intrinsic worth. Historically, this approach in investing, as in understanding the real frequency of these natural occurrences, provides HCM with a stable foundation, rewarding with steady returns over decades – a testament to the resilience of value investing and the power of compounding.
Historical Insight: The Dot-Com Bubble
A pivotal example that highlights the stability of value investing is the Dot-Com Bubble of the late 1990s. This period saw a surge in investments in internet companies, driven more by growth expectations than by fundamentals. When the bubble burst in the early 2000s, it led to significant market corrections and the permanent loss of capital. Investors who adhered to value investing principles, focusing on fundamental valuations, were better insulated from these dramatic market fluctuations. This event underscores the importance of maintaining a disciplined approach to investing, as championed by HCM.
Section 2: The Siren Call of the Case Rate – Growth Investing Growth investing, on the other hand, epitomizes the case rate, much like the incidence of lightning strikes. The odds of being struck by lightning in a given year are about 1 in 500,000, yet the event is dramatic and powerful, capturing everyone’s attention. This is similar to the periods in growth investing, like from 2017 to 2020, where companies like Facebook, Apple, Netflix, Microsoft, Amazon, Google, and even Tesla saw their valuations soar, often detached from traditional valuation metrics. The tech-driven growth stocks soared to new heights, resembling capturing lightning in a bottle – exhilarating but often fleeting. However, just as one would approach a thunderstorm with caution, aware of the relatively low but impactful chance of a lightning strike, HCM views such explosive growth periods with a discerning eye, recognizing the volatility and risk inherent in such growth-focused strategies.
Section 3: Navigating Market Cycles with a Value Investing Compass Using the insights from these case rate periods to reinforce investment philosophy, while growth stocks may lead the charge during certain market phases, the fundamental principles of value investing remain HCM’s guiding star. HCM believes in the importance of not overpaying, regardless of market euphoria. It’s about finding quality stocks at reasonable prices and holding onto them through market cycles.
Empirical Evidence: The Long-Term Outperformance of Value Investing To solidify HCM’s discussion with empirical data, we present a pivotal chart that outlines the performance of the value factor over time, courtesy of the data compiled by Kenneth R. French from his renowned data library, specifically the Fama French Factor-HML, representing the value premium. The data spans from 1926 to September 30, 2023, offering a comprehensive view of nearly a century’s performance.
This chart vividly illustrates the long-term outperformance of value investing or the base rate from the starting point of 1926 right up to September 30, 2023. The value factor—measured as the difference in returns between high book-to-market stocks and low book-to-market stocks—shows a general upward trajectory, indicating that over this extended period, value investing has historically outperformed growth investing.
Conclusion: As we conclude, let this analysis serve as a reminder of the enduring strength and resilience of value investing. It echoes the sentiment that while the market may occasionally be swept up in the exuberance of growth stocks, it’s the steadfast commitment to finding undervalued assets that has historically paid off. For those with the foresight to look beyond the transient dazzle of growth, the enduring strength of value investing lies in wait.