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Value Premium

Is there a reliable benefit from conventional value investing (based on the book-to-market value ratio)? these blog entries relate to the value premium.

Fama-French 5-factor Model and Global Stocks

Does the Fama-French  5-factor model (market, size, book-to-market, profitability, investment) of stock returns work for stocks worldwide? In their May 2021 paper entitled “Size, Value, Profitability, and Investment Effects in International Stock Returns: Are They Really There?”, Nusret Cakici and Adam Zaremba test the performance of the 5-factor model in global developed markets. They consider big and small stocks separately. They consider four regions (North America, Europe, Japan and Asia-Pacific), as well as the global market. They lag all accounting data by six months and calculate returns in U.S. dollars. Using data in U.S. dollars for 65,000 stocks from 23 countries during December 1987 through March 2019 (with tests starting July 1990), they find that:

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Book-to-Market Ratio Failing But Still Loved

Is firm book value-to-market price ratio (B/M) obsolete due to growing importance of intangible assets? Is it still widely used by institutional investors? In their May 2021 paper entitled “Going by the Book: Valuation Ratios and Stock Returns”, Ki-Soon Choi, Eric So and Charles Wang examine continuing of B/M for value investing and implications of such use for stock returns and trading. They compare its effectiveness to: sales-to-price; gross profit-to-price; net shareholder payout-to-price; and, a composite of these three alternatives (COMP). They focus on firms with significant deviations between B/M and the other ratios to assess how investors price and trade stocks with conflicting value signals. Specifically, they each year at the end of June:

  • Calculate each ratio for each firm.
  • Rank firms into fifths (quintiles) based on each ratio.
  • Calculate the absolute difference in quintile between B/M ranking and ranking based on other ratios (RatioSpread).

High values of RatioSpread indicate firms for which B/M disagrees with other ratios regarding whether associated stocks are value or glamor (growth). Using firm fundamentals and stock trading data for a broad sample of U.S. stocks with share price over $5 during 1980 through 2017, they find that: Keep Reading

Factor Crowding in Commodity Futures

Can investors detect when commodity futures momentum, value and carry (basis) strategies are crowded and therefore likely to generate relatively weak returns? In the March 2021 version of their paper entitled “Crowding and Factor Returns”, Wenjin Kang, Geert Rouwenhorst and Ke Tang examine how crowding by commodity futures traders affects expected returns for momentum, value and basis strategies. They define commodity-level crowding based on excess speculative pressure, measured for each commodity as the deviation of non-commercial trader net position (long minus short) from its 3-year average, scaled by open interest. They calculate crowding for a long-short strategy portfolio as the average of commodity-level crowding metrics of long positions minus the average of commodity-level crowding metrics for short positions, divided by two. They specify strategy portfolios as follows:

  • Momentum – each week long (short) the equally weighted 13 commodities with the highest (lowest) past 1-year returns as of the prior week.
  • Value – each week long (short) the equally weighted 13 commodities with the highest (lowest) ratios of last-week nearest futures price to nearest futures price three years ago.
  • Basis – each week long (short) the equally weighted 13 commodities with the highest (lowest) basis, measured as percentage price difference between nearest and next maturity contracts as of the prior week.

For each strategy, they measure effects of crowding by measuring returns separately when strategy crowding is above or below its rolling 3-year average. Using weekly (Tuesday close) investor position data published by the Commodity Futures Trading Commission (CFTC) for 26 commodities traded on North American exchanges during January 1993 through December 2019, they find that:

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Measuring the Value Premium with Value and Growth ETFs

Do popular style-based exchange-traded funds (ETF) offer a reliable way to exploit the value premium? To investigate, we compare differences in returns (value-minus-growth, or V – G) for each of the following three matched pairs of value-growth ETFs:

  • iShares Russell 2000 (Smallcap) Growth Index (IWO)
  • iShares Russell 2000 (Smallcap) Value Index (IWN)
  • iShares Russell Midcap Growth Index (IWP)
  • iShares Russell Midcap Value Index (IWS)
  • iShares Russell 1000 (Largecap) Growth Index (IWF)
  • iShares Russell 1000 (Largecap) Value Index (IWD)

To aggregate, we define monthly value return as the equally weighted average monthly return of IWN, IWS and IWD and monthly growth return as the equally weighted average monthly return of IWO, IWP and IWF. Using monthly dividend-adjusted closing prices for these ETFs during August 2001 (limited by IWP and IWS) through March 2021, we find that: Keep Reading

Remaking Value Investing

Value investing performance over the past two decades is poor. Is this underperformance a temporary consequence of an unusual macro environment, or a reflection of permanent economic/equity market changes. In their February 2021 paper entitled “Value Investing: Requiem, Rebirth or Reincarnation?”, Bradford Cornell and Aswath Damodaran survey the history and alternative approaches to value investing, with focus on its failure in recent decades. They then discuss how value investing must adapt to recover. Based on the body of value investing research through 2020, they conclude that: Keep Reading

Only One Way to Win?

Why have so many quantitative funds performed poorly in recent years? In his January 2021 paper entitled “The Quant Crisis of 2018-2020: Cornered by Big Growth”, David Blitz examines in detail recent (June 2018 through August 2020) performance of stock portfolios constructed from five widely accepted long-short factors:

  1. Size – Small Minus Big (SMB) market capitalizations.
  2. Value – High Minus Low (HML) book-to-market ratios.
  3. Investment – Conservative Minus Aggressive (CMA).
  4. Profitability – Robust Minus Weak (RMW).
  5. Momentum – Winners Minus Losers (WML).

Using factor returns from the Kenneth French data library and additional firm/stock data for developed and U.S. markets to construct alternative factor performance tests from various start dates through August 2020, he finds that: Keep Reading

Recent Weaknesses of Factor Investing

How have value, quality, low-volatility and momentum equity factors, and combinations of these factors, performed in recent years. In their October 2020 paper entitled “Equity Factor Investing: Historical Perspective of Recent Performance”, Benoit Bellone, Thomas Heckel, François Soupé and Raul Leote de Carvalho review and put into context recent performances of these these factors/combinations as applied to medium-capitalization and large-capitalization World, U.S. and European stock universes. They consider both long-short and long-only factor portfolios and further investigate effects of (1) neutralizing beta and sector dependencies, (2) using multiple metrics for each factor and (3) including small stocks. Using firm accounting data and stock returns to support factor portfolio construction during 1995 through early 2020, they find that:

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Reversions from Stock Market Valuation Extremes Drive the Value Premium?

Do extreme equity market valuations represent opportunities in value stocks? In their October 2020 paper entitled “Extrapolators at the Gate: Market-wide Misvaluation and the Value Premium”, Stefano Cassella, Zhaojing Chen, Huseyin Gulen and Ralitsa Petkova test the hypothesis that extrapolating (momentum) investors bid up growth stocks in good times and bid down value stocks in bad times, such that the value premium concentrates during reversion from these conditions. Their principal measure of market valuation is average book value-to-market capitalization ratio (B/M) of all firms, excluding financial stocks, utility stocks and stocks priced ice less than $1. When monthly B/M is in the top (bottom) 10% of monthly values for the past 10 years, they deem the market overvalued (undervalued). For robustness, they consider other percentage cutoffs and an alternative metric that quantifies the distance between the current-month distribution of firm B/Ms and the distributions of over the past 10 years based on the Mann-Whitney U test. They further tie findings to investor expectations based on a long times series constructed from Gallup, American Association of Individual Investors and Investor Intelligence surveys of investors. Using monthly returns and accounting data for U.S. common stocks and the specified survey data during January 1962 through December 2018, they find that:

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Adjusting the Value Premium for a Knowledge Economy

Has growth in the importance of intangible (knowledge) assets versus real assets undermined usefulness of the conventional equity value premium (based only on the latter)? In her September 2020 paper entitled “Intangibles: The Missing Ingredient in Book Value”, Feifei Li explores whether including intangible assets when calculating book value better measures firm fundamental value. She divides intangible assets into research and development (R&D) and selling, general and administrative (SG&A) components. She assumes that both depreciate at 15% annually, but only 30% of the latter translates to capital investment. She constructs intangible value factors based on the conventional value factor calculation methodology but adding either R&D assets or both R&D and SG&A assets to calculate book value. She looks at effects of these additions on both the long (value stocks) and short (growth stocks) sides of the value premium portfolio. She focuses on U.S. stocks but checks robustness of findings across UK, continental Europe, Japan and Asia ex Japan regions. Using data for U.S. stocks commencing July 1951, and for other regions commencing July 1995, all through November 2019, she finds that:

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Finding a Healthy Value Premium

Is there a way to restore confidence in a value premium? In their September 2020 paper entitled “Resurrecting the Value Premium”, David Blitz and Matthias Hanauer seek a reliable value premium via three adjustments to the conventional high-minus-low book-to-market ratio (HML) metric:

  1. Augment book-to-market ratio with three other value signals: earnings before interest, taxes, depreciation and amortization divided by enterprise value (EBITDA/EV); cash flow-to-price ratio (CF/P); and, net payout yield (NPY), essentially dividend yield plus share buybacks minus share issuance. Create a composite value score by normalizing each metric cross-sectionally (excluding financial stocks) using z-scores and then average individual z-scores.
  2. For developed markets, impose industry neutrality by independently ranking stocks within each of 11 sectors. For emerging markets impose neutrality at the country level.
  3. To assure liquidity, consider a universe of all stocks in the standard (large/mid-capitalization) MSCI indexes at that moment. Exploit this liquidity by using equal-weighted portfolios sorted into fifths (quintiles) by composite value score.

Using the specified value metric data, associated stock returns and returns for other standard equity factors as available through June 2020, they find that: Keep Reading

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