Earlier this week, we began discussing some of the more pervasive and enduring facts and fictions surrounding the value premium. But it’s important to understand that the value premium—a phenomenon in which securities that sell at low prices relative to fundamental metrics outperform on average securities that sell at high relative prices—is an empirical fact.
As I mentioned previously, the premium’s existence is evident in 87 years of U.S. equity data, in more than 30 years of out-of-sample evidence from the original studies, in 40 other countries and in other asset classes (bonds, commodities and currencies).
Today we will resume taking on the many myths and misperceptions about value investing. We’ll continue to use the April 2015 paper from Cliff Asness, Andrea Frazzini, Ronen Israel and Tobias Moskowitz, “Fact, Fiction, and Value Investing,” as our roadmap.
Fiction: Value is “redundant”
Recently, professors Eugene Fama and Kenneth French advanced their new Five-Factor Model (FFM). The new model expands their three factor model (which consisted of the market (RMRF), size (SMB) and value (HML) factors) by adding two new factors (a “profitability” (RMW) factor and an “investment” (CMA) factor).
Some observers made a big deal out of claims that the pair’s original value factor, HML (high minus low), was “redundant.” They argued it added nothing beyond the model’s other four factors in terms of explaining returns.
This created enough of a stir that Fama and French themselves decided to write about it. They explain: “When we say that HML is redundant, what we mean is that its average return is fully captured by its exposures to the other factors of the five-factor model. This means HML has no information about average returns that is not in other factors, so we do not need HML to explain average returns.”
However, the authors of our study then go even further. They write: “It doesn’t mean that value is an ineffective strategy stand-alone, far from it. It simply means that after accounting for the two new factors, value does not add additional [emphasis mine] returns. If your value-based view of the world has been rocked and you find this at all disturbing, you are overacting. Again, value is still a good strategy.”
They demonstrate this by adding back momentum to the model and removing the lag in the data. Standard construction of HML employs annual rebalancing in June. Using book-to-price as the valuation measure to decide “H” and “L,” where both book and price are taken as of the prior December, eliminates the redundancy.
Fact: Value investing is applicable to far more than just choosing what stocks to own or avoid
It’s been well-documented that significant “value” return premiums occur not just in equities, but also in bonds, commodities and currencies (in what’s known as the “carry trade”). It has also been discovered that the correlation of value strategies across asset classes is positive—cheap assets in one asset class move with cheap assets in others.
Fact: Value can be measured in many ways, and is in fact best measured by a composite of many variables.
In their work, Fama and French made one particular value measure, the book-to-market ratio, very popular. However, the authors of our study note that there is no theoretical justification for it as the “true measure” of value versus other reasonable competitors.
In fact, the authors cite a study by Fama and French in which they used a variety of fundamental-to-price ratios (such as earnings-to-price and cash flow-to-price) as well as other measures of value (such as dividend yield, sales growth and even reversal of the past five-year returns, known as the “poor man’s” value measure). Indeed, Fama and French found that the results were consistent across measures, and the portfolios constructed from different value measures yield highly correlated returns.
The authors presented evidence that from 1951 through 2014, while the book-to-market measure produced an annual value premium of 3.6 percent, the price-to-earnings measure produced a premium of 5.3 percent, and price-to-cash flow produced a premium of 4.5 percent.
On the other hand, the dividend-to-price measure produced a premium of just 1.8 percent and the five-year reversal measure produced a premium of 2.5 percent. A composite of the five measures produced a premium of 3.5 percent, virtually identical to the book-to-market measure. However, due to the nonperfect correlation of the metrics, the volatility of the composite HML portfolio is 20 percent lower.