In 1981, Sanjoy Basu’s paper, “The Relationship Between Earnings’ Yield, Market Value and Return for NYSE Common Stocks,” found that the positive relationship between the earnings yield (E/P) and average return is left unexplained by market beta.
Then, in 1985, Barr Rosenberg, Kenneth Reid and Ronald Lanstein uncovered the positive relationship between average stock returns and book-to-price (B/P) ratio in their paper, “Persuasive Evidence of Market Inefficiency.”
Together, these two studies provided evidence that a value premium existed. And even though there are several different metrics that can be used to determine value—such as E/P, B/P, dividend-to-price (D/P), cash flow-to-price (CF/P), sales-to price (S/P) and EBITDA-to-price (EBITDA/P) ratios—since the 1992 publication of Eugene Fama and Kenneth French’s seminal paper, “The Cross-Section of Expected Stock Returns,” the most commonly used metric has been book-to-price.
In their May 2015 paper, “Optimizing Value,” Ran Leshem, Lisa Goldberg and Alan Cummings of the Aperio Group investigated how the choice of accounting metric, and the implementation of it, affect the performance of a value strategy. Using the data from Kenneth French’s website, as well as from MSCI Barra, they examined outcomes from two value metrics—B/P and E/P (the earnings yield, or earnings-to-price ratio—for the period 1951 through 2013.
The authors found that while strategies based on either B/P or E/P each delivered positive premiums over the full period, the E/P metric outperformed B/P by, on average, 1.17 percentage points per year (15.99 versus 14.82). What’s more, it did so with slightly less volatility.
However, the results weren’t uniform over the full period. They noted that over the period covered in the original Fama and French paper (July 1963 through December 1990), B/P outperformed E/P by 1.06 percentage points per year (15.35 versus 14.29), and that it did so with virtually the same volatility. In the subsequent period (January 1991 through December 2013), E/P outperformed B/P.
Diversification Blend Outperforms
The authors also found that, due to a diversification benefit, a 50/50 blend of B/P and E/P outperformed both single-metric strategies during most 10-year periods between 1973 and 2013. The blended strategy had the highest annualized return: 14.21 percent per year over the period January 1973 through December 2013, followed by E/P with 13.48 percent per year and B/P with 12.79 percent per year.
Turning to risk, E/P had the lowest standard deviation, coming in at 16.41 percent versus 17.36 percent for the blended strategy, and 18.79 percent for B/P. E/P also had the lowest tracking error against the S&P 500 Index: 7.04 percent versus 8.13 percent for the blended strategy, and 9.27 percent for B/P. The blended strategy had the highest Sharpe ratio, at 0.53, versus 0.52 for E/P and 0.44 for B/P. Turnover rates were similar and, as a result, so were estimated trading costs (they were within 1 basis point).
Tracking Error Risk
Leshem, Goldberg and Cummings also found that investors concerned with the tracking error risk of value-tilted portfolios should consider using an approach that constrains the divergence in sector weightings to the index while still maintaining the value tilt.
Using the S&P 500 as their benchmark, the authors found that restricting the sector weights to within 1 percent of the benchmark weightings could cut tracking error by more than 50 percent, while also reducing turnover and transaction costs (by about 10 bps). Over the period studied, the sector-constrained approach outperformed as well.