How Dr Phil Hofflin separates the signals from the noise (and uses the value premium to supercharge returns)

• Say we've got an index that has exactly 10 stocks in it and they each earn $1, and they each grow their earnings by 10%;
• 1/10th of those stocks every year will have a disaster. And in that year, it earns absolutely zero;
• So in the first year, we've got nine stocks earning $1 and one earning zero;
• And then the bottom-up analysts get to work and say, well, what are these stocks going to earn next year?
• They quite correctly say that all 10 stocks will earn $1.10, which is the correct assumption 90% of the time. 

At first glance, this all makes perfect sense. But there's a problem. 

"You do all the bottom-up detailed work and you add it up and you almost know it's gonna be wrong because there is an element you can't incorporate - the random fact that the future unfolds," says Hofflin. 

There are two layers of "noise" here. 

"There's the 20% that is the future unfolding, and on top of that, it's the 80%. That's noise. It's the exaggeration, it's the overreactions and so forth," Hofflin says. 

Invest for value to achieve growth

At the portfolio level, value investing beats growth investing at its own game. 

"Value portfolios win because they have better growth," Hofflin argues. 

Don't believe him? It's not a subjective call.

Kenneth French, Roth Family Distinguished Professor of Finance at the Tuck School of Business at Dartmouth College, maintains a database that tracks model growth and value portfolios using data dating back to 1926.

Here's a snapshot of the recent performance between his modelled portfolios over 12 months to December 22, 2022. 

"He does something really simple. Just classifies once a year, he goes out, takes all the S&P stocks, puts them in, sorts them by price to book, puts the lowest price to book 30% as the value category, the highest 30% as the growth category, and follows the performance for a year," says Hofflin. 

Over that time, the value portfolio is now ahead by 3100% or 31 times. Importantly, it's 3% or so ahead of the growth portfolio. 

So what explains the divergence in performance?

"Well, it could in principle come from two things, earnings or multiples," Hofflin says. 

"The only way this could have possibly happened is for the earnings, for the value portfolio, to have grown dramatically more."

How do we explain that? It all has to do with the value premium, which provides the value investor with the opportunity to buy stocks that are undervalued on a pretty consistent basis. 

Not convinced? Don't worry, Hofflin has you covered with another earnings hypothetical. Again, while it's a hypothetical, the logic is anything but. 

"Let's say I'm a value manager and I've got a stock and it's done pretty well, it's up 15 times. And I say, you know what, I'm happy with this stock," he says. 

"But it's 15 times, I think it's pretty fully valued over a stock on 10 times. Now, I take my money and I put it in the stock trading on 10 times. I have just grown my earnings by 50%.

"I've gone from a 15 times stock to a 10 times stock. So the earnings have gone by 50%."

The average company takes about eight years to do that. Hofflin just did it in two trades. Try doing that by investing in growth stocks. 

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