It’s going to be a brief one since I’m traveling. No posts next week for the same reason.
While digging for stuff on Walter Schloss a few weeks ago, I found a short research piece he and Ben Graham helped on. The piece was published in January of 1951. It studied the performance of the “cheap” versus “dear” stocks in the Dow from 1914 to 1948.
It turns out the “dear” stocks outperformed “cheap” and the Dow in the first half of the period (1914 – 1931) in the run-up to the 1929 peak. But the “cheap” stocks extreme outperformance in the second half (1932 – 1948), drove it to outperform “dear” over the entire period.
The strategy implied is not something to use today but the explanation might sound familiar:
The following is advanced as a tentative explanation of these rather perplexing market phenomena. Let us assume that the Dow Jones list consists of 30 large companies, with considerable variations in the quality and apparent long-term prospects, but all possessing the characteristic of resiliency — i.e. the power to recover from adversity. Assume further that the average price-earnings ratios reflect accepted views as to differences in quality… It might be expected then that the relative price behavior of the individual issues would follow a pattern similar to that of the market as a whole — which means that favorable developments or prospects would tend to receive an exaggerated response on the upside, and conversely for unfavorable ones. In due course these exaggerations would be corrected. In the aggregate the issues that had gone up more than the market as a whole would be found to have advanced too far, and they would lose ground, relatively, in subsequent years. Similarly, those that had lagged behind the market would prove to have over-emphasized their unfavorable factors; thus they would subsequently advance more than the market as a whole. The relative action of our Cheap Stocks and Dear Stocks between 1932 and 1948 would seem to conform to this hypothesis.
Why did not this explanation hold good for the earlier years? We suggest the following as the reason. During 1914-1931 the market was gradually establishing those wide quality-differentials which have been so prominent a feature of common stocks ever since the New Era bull market of the late 1920s. In 1914 the dividend yields and earnings multipliers for our large companies were rather homogenous; but as time went on, the “good stocks” — meaning particularly those with favorable earnings trends — became valued more and more generously vis-a-vis the “lower quality” issues. This bias in favor of the quality issues was an accelerating affair; its result was to favor the good stocks in the market year after year, even though they had already outperformed the rest of the list. This bias continued through the great depression culminating in 1932. In those years the quality issues appeared to justify the favor previously accorded them because they showed better resistance to the hard times.
We suggest finally that the quality differentials had been fully established by 1932, so that the bias in favor of the good stocks was now completely reflected in their prices. From then on the basic element of fluctuations reasserted itself: good stocks, like good markets, went up, too high; unpopular stocks, like unpopular markets, went down, too far.
There’s a little of everything in there: the history pre- and post-1929 crash, the value versus growth phenomenon in the competing periods, and mean reversion. Here’s the piece with data included: A Simple Formula for Common Stock Investment (pdf).
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