Magazine Issue: July 6, 1998

How the Really Smart Money Invests

Part 3

Shawn Tully

What saved DFA during this period was that Sinquefield and Booth had not overpromised when selling the fund. They never told clients that small stocks would outpace big ones in any given period, even one lasting seven years. They did pledge that DFA would beat most competing small-cap funds, saddled as they were by high fees. And so it did: All small-cap funds underperformed the S&P, but DFA did better than most. Moreover, since the small-stock dry spell ended in late 1990, the 9-10 fund has waxed the S&P 500, the Russell 2000 small-stock index, and the average small-company mutual fund.

Then as now, DFA owed much of its outperformance to a fierce attention to costs. After all, in an efficient market, costs are the one thing you can control. In addition to charging low management fees, DFA gains on the competition by sharp trading. Part of its advantage is size: As the nation's largest market maker in small caps, DFA is the first stop for active managers desperate to buy or sell blocks of small stocks. Says Robert Deere, the head of trading: "We make it as painful for them as possible."

While the 9-10 fund remained a moderate success, it took another breakthrough by Fama to really push DFA into the big time. The study, conducted with Kenneth French, then of Yale, confirmed Banz's small-stock effect but also showed convincingly that the lower the company's ratio of price to book value, the higher its subsequent stock performance tended to be. No other measures had nearly as much predictive power--not earnings growth, price/earnings, or volatility. While "value" managers such as Warren Buffett and Michael Price had long maintained that it was smarter to buy companies when they were out of favor--thus trading at low price-to-book ratios--Fama and French proved the point with statistical rigor. According to Fama and French's most recent data, downtrodden "value" stocks have outpaced high price-to-book growth stocks annually by an average of 15.5% to 11% over the past 34 years.

What makes the numbers so dramatic is that growth stocks--the Coca-Colas and Gillettes--are inevitably the most highly regarded issues, with the most predictable earnings streams. The only problem is that you have to pay for that reliability. That leaves less room for future appreciation. Value stocks, by contrast, have low prices but big upside potential. They have to offer investors higher return to compensate for the extra risk of owning them, just as Kmart must offer higher rates to sell its bonds than Wal-Mart. In a way, the value effect is similar to the small-stock effect: Bigger risk pays off, in aggregate, with higher returns. In fact, small stocks that also trade at low price-to-book ratios provided the best results of all in Fama and French's study, returning an annual 20.2% over 70 years, eight points more than big growth stocks.

DFA was quick to launch a small- and a large-cap value fund based on Fama and French's research. The funds buy only stocks that fall into low price-to-book deciles, and they make no attempt to distinguish "better" value stocks from worse ones. Partly on the strength of Fama's research, the two funds have proved enormously popular and now contain some $8 billion. One believer is Robert Boldt of Calpers, which invests $1.7 billion with DFA. "I'm convinced the value effect is real," says Boldt. "You have to expect higher returns for investing in beaten-down companies."

With a certain amount of academic prudence, the DFA sages are careful to warn that their research is no substitute for a balanced investment plan. They don't, for example, recommend that you invest only in small-cap and value stocks; the two strategies sometimes badly underperform. For stability, they recommend holding about 45% of your equities in an S&P index fund.

None of that diminishes their evangelical--some would say arrogant--attachment to their strategies. The zealots at DFA believe that their methods have not only the weight of evidence behind them but also the force of history. "Today the only people who don't think markets work are the North Koreans, the Cubans, and the stock pickers," says Sinquefield.

Who could argue, given all the brainpower at DFA? Still, hope springs eternal in investors' hearts. The temptation to try to pick the next Microsoft or Peter Lynch is--let's face it--pretty hard to overcome. And besides, at least one DFA giant thinks it's okay to indulge such guilty pleasures as long as you recognize them for what they are. "I choose a few stocks myself," says Nobel laureate Merton Miller. "But I do it strictly for entertainment."

Fortune

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