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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.

Dynamics of Size and Value Investing

As companies evolve, their characteristics may migrate from one category to another (for example, from small to large, or from growth to value). Does such migration, in aggregate, help explain differences in average returns for different categories of stocks? In the August 2006 draft of their paper entitled “Migration”, Eugene Fama and Kenneth French investigate how migration of firms across categories contributes to the size effect and the value premium. Specifically, at the end of each June from 1926 through 2004 they construct six value-weighted portfolios of stocks from the major U.S. exchanges based on market capitalization and price-to-book ratio. They then examine the effects on portfolio returns of four kinds of annual rebalancing actions: (1) firms that do not move (Same); (2) firms that change size (dSize); (3) firms that improve toward growth, or are acquired (Plus); and, (4) firms that deteriorate toward value, or are delisted (Minus). Using subsequent-year return data for 1927-2005, they conclude that: Keep Reading

Classic Research: Separating Cash Flow and Discount Rate Contributions to Stock Returns

We have selected for retrospective review a few all-time “best selling” research papers of the past few years from the General Financial Markets category of the Social Science Research Network (SSRN). Here we summarize the August 2003 paper entitled “Bad Beta, Good Beta” (download count over 1,700) by John Campbell and Tuomo Vuolteenaho. In this research, the authors separate stock beta into two components, one reflecting news about cash flows and one reflecting news about discount rates. They apply this decomposition to explain the size effect and the value premium. They hypothesize that:

[Market] “value…may fall because investors receive bad news about future cash flows; but it may also fall because investors increase the discount rate…that they apply to these cash flows. In the first case, wealth decreases and investment opportunities are unchanged, while in the second case, wealth decreases but future investment opportunities improve. …[A]n investor may demand a higher premium to hold assets that covary with the market’s cash-flow news than to hold assets that covary with news about the market’s discount rates, for poor returns driven by increases in discount rates are partially compensated by improved prospects for future returns. …The required return on a stock is determined not by its overall beta with the market, but by its bad cash-flow beta and its good discount-rate beta. Of course, the good beta is good not in absolute terms, but in relation to the other type of beta.” [Underlining is ours.]

Using monthly returns from an early period (January 1929 through June 1963) and a modern period (July 1963 through December 2001) to test this idea, the authors conclude that: Keep Reading

Why Highly Volatile Stocks Tend to Underperform

Conventional wisdom holds that: (1) risk begets reward; and, (2) volatility is a manifestation of risk. Exceptionally high volatility in individual stock prices should, therefore, indicate future excess returns in those stocks. In their May 2006 paper entitled “The Relation between Time-Series and Cross-Sectional Effects of Idiosyncratic Variance on Stock Returns in G7 Countries”, Hui Guo and Robert Savickas investigate why the realized idiosyncratic volatility (beta) of individual stocks correlates negatively with future returns — why there is a penalty instead of a reward for this apparent risk. Using two sets of U.S. data (1926-2005 and 1963-2005) and one set of international data (1973-2003), they conclude that: Keep Reading

Capturing the Value Premium by Avoiding Institutional Ownership

Which cheap (high book-to-market value) stocks drive the value premium? Can investors capture the value premium by simply buying a broad index of value stocks, or should they focus on some easily identifiable subset. The paper “Institutional Ownership and the Value Premium” by Ludovic Phalippou from April 2005 evaluates level of institutional ownership as the driver of the value premium, hypothesizing that mispricing of stocks is mostly like to come from unsophisticated individual investors. Using data for 1980-2001, he concludes that: Keep Reading

Combining Momentum and Value for Industry Rotation

Value and momentum are two very different equity investing styles, both with many adherents. Neither outperforms the overall market all the time. Is there some systematic way of combining these two approaches to enhance consistency of outperformance in global equity markets? In their March 2006 paper entitled “Generating Excess Returns through Global Industry Rotation”, Geoffrey Loudon and John Okunev examine different investing styles (momentum, value, combination of value and momentum, and growth) to exploit cyclic industry returns, with the U.S. yield curve as the critical economic indicator. Using monthly global prices, dividends, earnings and returns data for 36 industries for 1973-2005, they conclude that: Keep Reading

(Not) Capturing the Elusive Value Premium

Do long-term value investors outperform? In their paper entitled “Do Investors Capture the Value Premium?”, Todd Houge and Tim Loughran seek the answer to this question by examining groups of value and growth equity indexes, mutual funds and individual stocks over long periods. They conclude that: Keep Reading

Challenging the Value Premium

Current research on the value premium, the outperformance of value stocks in comparison with other (growth) stocks, mostly involves explaining it through either behavioral or efficient-market mechanisms. However, in their November 2005 paper entitled “Does the Value Premium Really Exist in the UK Equity Market?”, Panagiotis Andrikopoulos, Arief Daynes, David Latimer and Paraskevas Pagas challenge its existence. Their study focuses on eliminating any possible effects of survivorship bias, look-ahead bias and the method of calculating returns in comparing the performance of value and growth stocks of United Kingdom firms. They classify value versus growth via four selection factors (low for value, high for growth): book-to-market value, earnings-to-price ratio, dividend yield and weighted average sales growth. Using a new database of 2006 UK equity issues fully listed at any time during 1987-1996, they find that: Keep Reading

Value Versus Growth When the Economy Is Bad

Does value beat growth because: (1) investors/traders irrationally overreact to recent bad (good) news about value (growth) stocks; or, (2) they rationally recognize that value stocks are inherently more risky than growth stocks? In their March 2005 paper entitled “Value versus Growth: Movements in Economic Fundamentals”, Yuhang Xing and Lu Zhang seek to clarify the value-growth contest by examining how the fundamentals (earnings growth, dividend growth, sales growth, investment growth, profitability and investment rate) of value and growth companies behave during different parts of the business cycle. Using two samples for manufacturing companies for 1963-2002 and 1928-2002 and defining “value” (“growth”) as the top (bottom) 20% in book-value-to-market capitalization, they find that: Keep Reading

Book (Value) It?

In the September 2005 version of their paper entitled “The Anatomy of Value and Growth Stock Returns”, Eugene Fama and Kenneth French separate the average returns on both value and growth portfolios into dividends and three sources of capital gains: (1) reinvestment of earnings (growth in book value); (2) change in price-to-book ratios (P/B) due to mean reversion in profitability, and (3) a secular upward drift in P/B. Using data spanning 1926-2003 for NYSE, AMEX and NASDAQ stocks, they find that: Keep Reading

Value Versus Growth: The Winner Is…

In their August 2005 paper entitled “Value Versus Growth: Stochastic Dominance Criteria”, Abhay Abhyankar, Keng-Yu Ho and Huainan Zhao apply stochastic dominance techniques to assess the relative performance of value and growth investment strategies in U.S. equity markets over the past half century. These techniques: (1) compare entire return distributions (not just means or medians); (2) are independent of specific asset pricing models; and, (3) require only minimal assumptions about investor preferences. In this application, the assumptions are that investors always want more wealth, are risk-averse and accept small high-probability losses in exchange for huge low-probability returns. With these assumptions, stochastic dominance implies generation of greater wealth. Using a full sample covering 1951-2003 and a sub-sample covering 1963-1990 from the Kenneth French database, they find that: Keep Reading

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