Swedroe: Value Investing Facts And Fiction

A recent academic paper delves into some truths and common misconceptions about value investing.

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

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.

Fact: 'Fundamental Indexing'” is—and only is—systematic value investing.

In recent years, there has been a proliferation of index mutual funds and exchange-traded funds, all based on a seemingly endless array of indexes designed to be “new and improved” versions of market-cap-weighted vehicles. Much of this has come to be called “smart beta.”

The proponents of “smart beta” claim to provide higher returns due to superior construction strategies. This assertion arises from the belief that market-cap weightings lead to an index overweighting “overpriced” stocks and underweighting “underpriced” stocks.

The smart-beta proponents believe the impact of pricing errors can be reduced by weighting holdings according to fundamental factors, such as price-to-book ratios, price-to-earnings ratios, dividend-to-price ratios, sales-to-price ratios and cash flow-to-price ratios. Among the leaders in this charge have been the proponents of the Fundamental Index concept developed by Research Affiliates.     

In their study, the authors show this is really just a marketing gimmick, one that allows the providers of smart beta to earn a fee from marketing their strategy and licensing their indexes. They also present evidence demonstrating that the returns of the Fundamental Indexes have nothing to do with “mispricings” and “overvaluations,” but really are well explained by loading on the HML (high minus low) value factor.

They do add that they are in favor of the multiple value metrics that Fundamental Indices use rather than simply relying on the single metric of book-to-market. And fund families that run value portfolios (such as Bridgeway, Vericimetry and AQR) each use multiple value metrics.

Fact: Profitability, or quality measures, can be used to improve value investing and still be consistent with a risk-based explanation for value.

Using the value factor together with measures of firm quality can identify the cheap and promising companies. The authors show evidence that a simple 60/40 combination of value with profitability has improved a value strategy’s Sharpe ratio.

They also show that a 60/40 combination of value with momentum results in an even bigger improvement in a value strategy’s Sharpe ratio. They then show that equal weighting value, momentum and profitability produces an even larger improvement in Sharpe ratio.

The authors go on to observe that both profitability and especially momentum are strongly negatively correlated with value, and both have provided a premium. This makes profitability and momentum important factors for adding value to a portfolio, although it does become harder to reconcile that from an efficient markets (though not behavioral) point of view.

Thus, the authors agree with my own viewpoint that the value premium is a result of a combination of both risk and behavioral factors. Already it appears that this paper has successfully dispelled a number of persistent misperceptions about value investing. But there’s more analysis to come. Later this week, we’ll address additional facts and fictions about the value premium.

Larry Swedroe is the director of research for the BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country.