This paper makes the case that today is as compelling a time to buy the highest quality Midcap firms trading at below-market prices as it was at the peak of the internet bubble. Our primary points are as follows:
1. A Rare Entry Point: Midcap value has been decimated, creating a rare entry point for an asset class that has a 60-year history of generating high compound returns vs. Midcap & the S&P500
2. The Rise of the Wretched: Low-quality firms have rallied in a manner last seen only into the peak of the internet bubble
3. The Might of High-Quality Midcap Value: Purchasing High-Quality Midcap firms at below-average prices has historically offered investors some of the best risk-adjusted returns
Cheap High-Quality Midcap firms are abundant and compelling today, much as they were at the peak of the internet bubble when they subsequently trounced both the Midcap and S&P500 Indexes.
A fantastic paper from Mercer Consulting1 documents the long and successful history of value and its unusual struggle in the decade following the Great Financial Crisis. Notable for its resolute advocacy to “stay the course,” Mercer also references the two most common academic explanations for the historical outperformance of value. The first is that value outperforms only because you are being compensated for buying higher risk (lower quality) firms. The second is that investors are prone to behavioral errors resulting in overly pessimistic extrapolation of recent trends in value stocks and overly optimistic extrapolation of growth.
Kailash believes the market today is in the grip of an extreme behavioral error: firms with the least fundamental merit have soared as high-quality firms have been pushed into the bargain bin. This represents a generational opportunity for investors to purchase the best firms at below-average prices. Figure 1 shows the compound return of $1 invested in Midcap Value less $1 invested in the Midcap Index. Contrary to many headlines about a decade of underperformance2 and consistent with our papers Value Investing and Manias, Growth vs. Value, and 60/40 Asset Allocation, as well as research by GMO3, value’s headwinds only began in 2017. Value’s “lost decade” looks more to us like a few years.
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