Learning to Play Offense and Defense | #43

Episode Summary

Executive Summary: Meb Faber revisits a 2015 research paper on combining value and momentum for stock selection, then layering on a market-timing hedge for defense. The core message: a rules-based strategy can materially improve returns and reduce drawdowns versus the S&P 500, and hedging can make the strategy more tolerable for investors who struggle with volatility.

Main Topics: Value and momentum as the offensive engine (Priority: 5/5): The episode argues that buying cheap stocks that are also trending higher has historically outperformed broad market cap-weighted indexes. A simple, rules-based stock screen (Priority: 4/5): The transcript outlines a basic monthly screen using valuation and momentum ranks on large, liquid U.S. stocks, held equally weighted for three months. Performance of the VAMO portfolio versus the S&P 500 (Priority: 5/5): The value-plus-momentum portfolio generated substantially higher long-term returns, though with somewhat higher volatility and still-large drawdowns. Investor behavior and the case for defense (Priority: 5/5): The episode emphasizes that many investors cannot endure deep drawdowns and often panic-sell, making risk management as important as return generation. Market timing and hedging the broad market (Priority: 5/5): A simple defensive overlay is proposed: hedge when the market is expensive and/or in a downtrend, reducing drawdowns while preserving most of the alpha. Current market context and asset allocation implications (Priority: 4/5): As of March 2017, U.S. equities are described as expensive but still in an uptrend, while foreign developed and emerging markets appear cheaper and more attractive.

Key Arguments: Value and momentum are longstanding, empirically supported stock-selection factors, and the exact formula matters less than using them consistently. A long-only factor portfolio can outperform the market, but it still exposes investors to drawdowns that many cannot psychologically handle. Adding a simple hedge based on broad-market valuation and trend can substantially reduce drawdowns with only a modest sacrifice in return. Market timing often helps more by avoiding the worst losses than by dramatically increasing returns. Investor behavior, not just strategy design, is a major source of underperformance; many people buy high and sell low during stress. Cheap and rising markets are the best setup; expensive and falling markets are the most dangerous. The U.S. market in March 2017 looks expensive, so a hedge or alternative exposure may be more sensible for drawdown-sensitive investors.

Data Points: S&P 500 annualized return (1964-2014): 9.98% - Broad U.S. market return used as the benchmark. VAMO annualized return (1964-2014): Over 16% - Value + momentum stock-selection portfolio. S&P 500 volatility: 14.9% - Used to compare risk versus the factor portfolio. VAMO volatility: 18.7% - Higher than the market, but offset by higher returns. S&P 500 maximum drawdown: -50.95% - Worst peak-to-trough loss over the sample period. VAMO maximum drawdown: About -56% - Long-only factor portfolio drawdown, slightly worse than the S&P 500. S&P 500 Sharpe ratio: 0.33 - Risk-adjusted return of the broad market. VAMO Sharpe ratio: 0.62 - Risk-adjusted return of the long-only factor strategy. Hedged VAMO Sharpe ratio: 0.74 - Risk-adjusted return after adding the defensive overlay. Hedged VAMO maximum drawdown: About -27% - Drawdown roughly halved versus the long-only VAMO portfolio. Hedged VAMO volatility: Slightly less than the S&P 500 - The hedge reduced volatility materially. Worst five-year average return: S&P 500: -22.46% - Average of the five worst calendar-year periods since 1964. Worst five-year average return: VAMO: -19% - Comparable downside experience for the long-only factor portfolio. Worst five-year average return: Hedged VAMO: -2.24% - Much more tolerable during the worst periods. Average mutual fund investor return vs S&P (20-year period cited): 5.19% vs 9.85% - Dalbar data cited to show behavioral underperformance. CAPE ratio in March 2017: Around 30 - Used to indicate U.S. stocks are expensive relative to history. Historical average CAPE ratio: Around 17 - Long-run reference point for valuation. CAPE historical range mentioned: Low 5 to high 45 - Illustrates valuation extremes over time. Top-stock screen universe start year: 1964 - Simulation uses historical NYSE stocks back to this year. Portfolio construction: Top 100 value + top 100 momentum stocks, equally weighted, held for 3 months - Defines the offensive VAMO simulation.

Pivotal Quotes: "Nobody ever lost a game zero to zero." — Meb Faber: Football analogy used to explain why defense matters alongside offense in investing. "The fear of loss leads to withdrawal of capital at the worst possible time." — Dalbar (quoted by Meb Faber): Used to support the behavioral case for reducing drawdowns. "Unless you can watch your stock holding decline by 50% without becoming panic-stricken, you should not be in the stock market." — Warren Buffett: Cited to underscore that many investors are not suited to unhedged equity exposure.

Implications: The episode argues investors should optimize for a strategy they can actually endure: strong factor exposure plus a simple hedge can improve staying power, not just headline returns. For many, avoiding catastrophic drawdowns may matter more than maximizing upside.