Swedroe: A More Complex View On Value

March 29, 2017

  • Retained earnings-to-market subsumes book-to-market’s predictive power in the cross section of stock returns despite comprising, on average, only 42% of the book value of equity (book-to-market predicts the cross section of returns only because it contains retained earnings).
  • The accumulated dividends component of retained earnings is uninformative of the cross section of average returns (another example of dividend policy not being relevant to expected returns). The authors state: “This result is consistent with book-to-market’s explanatory power arising only because it provides a good proxy for expected earnings yield.”
  • Retained earnings-to-market is a significant predictor of future earnings yield, and thus returns, while contributed capital has no predictive power.
  • The value premium (the return on the high minus low portfolio) is greater using retained earnings-to-market than using book-to-market (43 versus 35 basis points per month) and has stronger statistical significance. Using only contributed capital, the value premium falls to 7 basis points per month and is no longer statistically significant (t-stat = 0.54).
  • Retained earnings predicts the cross section of stock returns out to seven years, while book-to-market predicts returns only as far out as three years.

Relative to the value premium, this last finding provides an argument against the mispricing (behavioral-based) theory, and for the risk-based theory. As the authors point out: “Why would the correction of mispricing occur gradually over a horizon that extends at least as far as seven years, especially bearing in mind that all this accounting information is made publicly accessible at essentially zero cost for all firms and all years?”

Finally, the fact that book-to-market’s explanatory power comes from the earnings component highlights the potential importance of including price-to-earnings and cash flow metrics instead of just BtM (as some investment firms do, such as Bridgeway Capital Management and AQR).

Another alternative is to include the new profitability factor in construction of value portfolios (as Dimensional Fund Advisors does), as retained earnings contain information about future expected earnings/profitability. It will be interesting to see if these findings will be incorporated into portfolio construction rules of funds that seek to capture the value premium.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.


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