Cheap Stocks Don't Outperform?

Well, I have to amend that title a bit. Cheap stocks have outperformed over the long term for the most part, but quality is the more reliable driver of superior performance. Jeremy Grantham, chairman of the $100+ billion asset management firm GMO, illustrates some of the pitfalls of investing purely on traditional Grahamian valuation metrics in his quarterly newsletter (starting on page 6). He certainly makes some compelling arguments, even if I don't necessarily agree with all of them. While I highly recommend reading the whole thing, I've also summarized his thoughts below:

Grantham begins by stating that we cannot ignore the massive booms and busts of the market and simply focus on individual stocks. He says that unappreciated, contrarian stock selections don't always "revert to the mean," thus it doesn't always pay to pick them out. On the other hand, each and every bubble at the asset class level has eventually popped.

He then goes on to attack the "traditional" Grahamian value tenet to invest in companies trading at a cheap price to book and price to earnings ratios (he focuses more on price to book). Grantham claims that low P/B (price to book) stocks are priced that way because their assets are of poorer quality, and therefore have more of a chance of financial strain in a recession or depression. He therefore labels P/B and P/E as risk factors, and shows that low P/B stocks took over twice as long as high P/B stocks to recover from the Great Crash in 1929.

He goes on to point out that with the exception of the Great Depression and the recent Great Recession, you typically made money buying these "cheap" stocks. However, he makes the point that when the "spread" between the highest P/B stocks and the lowest P/B stocks is wide, the cheap (low P/B) stocks tend to outperform, as they did in 2000. Conversely, if the "spread" is narrow, as it was in the early 1980's, then the cheap stocks will not outperform the market (they didn't for nearly 20 years).

Grantham claims that there are essentially three reasons why the "cheap" stocks outperformed for so long. First off, they carried a higher risk of financial failure. Secondly, many money managers faced career risks by buying these unattractive "cheap" equities. Lastly and most importantly, the investment community was more risk averse, thus overdiscounting the poor quality of these stocks. These factors ceased to exist starting in the 1980's as people realized that cheap stocks were outperforming.

Instead, Grantham shows that high quality stocks (classified by him as companies with high, stable returns on equity and low debt) have always outperformed the market. They recovered five times faster than low quality stocks after the Great Crash and have outpaced the market for as long as there is data.

While the points he makes are intriguing, I believe that cheap stocks and high quality stocks are not always mutually exclusive. Furthermore, I think that a selection of individual stocks that are both cheap and of high quality will eventually have their value recognized by the market. What are your thoughts?