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.
The authors go on to explain that “the valuation ratios, such as BE/ME, E/P, and CF/P, deliver better and more robust results than more tenuous measures such as negative past five-year returns and dividend yield.” This makes great sense, because past returns do not contain any information about a firm’s fundamentals, and because many firms do not pay dividends. Hence, we would expect both of those measures to perform worse than the other valuation ratios.
A simple composite of just the three other valuation ratios would generate a value strategy that produces an average return of 4.5 percent per year with an annualized Sharpe ratio of 0.48, both of which are higher than for book-to-market alone.
The authors also demonstrated that, by looking across all measures of value in each decade of the period studied, there were times when each value measure performed better or worse. That follows because there’s no theoretical reason to expect any one measure to be superior. In short, using multiple measures provides a diversification benefit.
Fact: Value as a stand-alone is surprisingly weak among large-cap stocks.
Over the entire period of the study, from 1926 through 2014, the market-adjusted return to value within small-cap stocks was a significant 5.5 percent per year. Within large-cap stocks, however, it was an insignificant (not statistically different from zero) 1.7 percent per year.
When the authors broke the full period into three subperiods, the only period where there was a significantly positive HML premium among large-cap stocks was during the in-sample period from 1963 through 1981, when the bulk of the original academic work on value took place.
During both out-of-sample periods, prior to these studies from 1926 to 1962 and after these studies from 1982 to 2014, there was no evidence of a healthy value premium among large-cap stocks. I’d note that for the whole period, even though the 1.7 percent premium wasn’t statistically significant, it’s certainly economically significant. At any rate, the value premium has been much larger and more significant in small-cap stocks.
The authors do note that once you combine value and momentum—while small-cap value still produces both higher returns and a higher Sharpe ratio—the gap narrows dramatically. This once again demonstrates the benefits of combining value with other strategies.
Fiction: Value’s efficacy is the result of a risk premium not a behavioral anomaly and is therefore in no danger of ebbing going forward
There’s an ongoing debate in the academic community as to whether the value premium results from risk, behavior or a combination of both. As the authors note, even the Nobel Prize committee couldn’t decide, splitting the award between Fama (risk-based) and Shiller (behavioral).
They go on to observe that both theories offer good reasons to expect the value premium to persist in the future. They also write that just because a premium is related to risk doesn’t mean that cash flows chasing the premium won’t greatly reduce the premium going forward.
Investors need to understand that even if the value premium isn’t risk-based and instead the result of mispricings, limits to arbitrage as well as the fear and cost associated with shorting and margin can allow mispricings to persist. The authors also point out that “there is no reason to think that there will not be enough maintained behavior on the part of irrational investors to keep the mispricing going. (In fact, the mispricing can get worse!)”
The authors make the important point that “both theories give us a good reason to believe in the value premium.” They point to the “evidence from more than a century of data in plenty of out-of-sample periods, in dozens of financial markets and different asset classes, and with no signs of getting weaker despite investor knowledge of value investing going back at least three decades is further testament that the value premium is not likely to disappear soon.”
I would add that we now have hundreds of billions of dollars invested in value strategies, and we even see behavioral-based value fund options (such as the J.P. Morgan Undiscovered Behavioral Value fund) in the marketplace. There’s no evidence that the value premium has disappeared.
The authors reached this conclusion: “in dispelling the myths about momentum in our prior paper, and detailing the facts and fictions about value in this one, we end up even stronger believers in both factors, and in particular their efficacy when used together.”
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.