Value is the phenomenon in which securities that sell at low prices relative to fundamental metrics (such as earnings, book value, cash flow, dividends and sales) on average outperform securities that sell at high relative prices. Specifically, the value premium is the annual average return realized by going long cheap assets and short expensive ones.
The existence of a persistent and pervasive value premium is well-established, empirical fact evident in 87 years of U.S. equity data, in more than 30 years of out-of-sample evidence from the original studies on the factor, in data from about 40 other countries and in other asset classes (bonds, commodities and currencies).
Cliff Asness, Andrea Frazzini, Ronen Israel and Tobias Moskowitz—authors of the April 2015 paper “Fact, Fiction, and Value Investing”—provide a valuable service by taking on many of the myths and misperceptions about value investing. Here is some of what they found:
Fiction: Value investing can only be successfully implemented with a concentrated portfolio.
To be a successful value investor, the authors explain, many people believe “you have to apply value in a concentrated portfolio, deeply understanding each and every security in order to uniquely identify cheap stocks?” They note Warren Buffett thinks so. He is quoted in the study as saying, “Diversification is protection against ignorance. It makes little sense if you know what you are doing.”
The authors then add: “Picking the exact right small handful of value stocks may, or may not, be possible, but it certainly does come with both additional dangers (if you’re wrong about one of a handful it matters a lot!) and additional upside (if you get it massively right for 50 years you get to be Warren Buffett!), and usually comes with a higher fee if purchased in the active management world.”
You don’t have to take the risks associated with a concentrated portfolio—nor do any fundamental research—to earn the value premium; simply buying stocks that meet the definition of being cheap is enough. To demonstrate this point, let’s take a look at the returns of U.S. value funds from Dimensional Fund Advisors (DFA). (Full disclosure: My firm, Buckingham, recommends DFA funds in constructing client portfolios.)
The data in the table below provides the annualized returns from April 1993 through March 2015 for the two DFA U.S. value funds and index benchmarks.
Value Funds And Benchmarks, April 1993-March 2015
|S&P 500 Index||9.29%|
|MSCI US Large Cap Value Index||9.37%|
|DFA US Large Cap Value (DFLVX)||10.31%|
|MSCI US Small Cap Value Index||11.37%|
|DFA US Small Cap Value (DFSVX)||12.51%|
As you can see, not only did the value indexes outperform the broad market, but the broadly diversified value funds from DFA also outperformed, earning their investors significant value premiums.
Fiction: Value is a passive strategy because it’s rules-based and has low turnover.
Those favoring passive strategies cite the evidence that passive strategies are more likely to allow investors to achieve their financial goals. Unfortunately, there’s no generally accepted definition of active versus passive investing.
The authors explain that any portfolio that deviates from the market portfolio is one that involves an active decision. The real issue, then, becomes how that decision to deviate from the total market is implemented, either actively or passively.
Some would define “active management” to mean individual stock selection and/or market timing. I believe that is University of Chicago professor Gene Fama’s definition. Thus, a broadly diversified, rules-based portfolio with low turnover would meet the criteria.
The authors, on the other hand, make a different distinction. They don’t attempt to distinguish between “active” and “passive.” Instead, their distinction is whether a strategy is “judgmental” or “systematic.” That’s a perfectly logical difference. A benefit of this definition is that it avoids the negative connotation the term “passive” has for many.