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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.

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

Value Investing Not Dead?

Based on the conventional definition of the value premium, value underperforms growth over last 13.5 years with maximum drawdown of a long value-short growth portfolio -55%. Is value investing dead? In the August 2020 update of their paper entitled “Reports of Value’s Death May Be Greatly Exaggerated”, Robert Arnott, Campbell Harvey, Vitali Kalesnik and Juhani Linnainmaa examine arguments that value investing is dead. They first employ bootstrapping to estimate the likelihood of the recent deep value premium drawdown by resampling 6-month value factor returns 1,000,000 times using the historical sample up to December 2006. They then examine the historical context of recent behaviors of each of three components of the value premium:

  1. Migration rates of value (growth) stocks toward growth (value) due to mean reversion of the underpinning valuation ratio.
  2. Relative profitability of value stocks versus growth stocks.
  3. Relative valuation (average price-to-book value ratio) of value stocks versus growth stocks.

They assess statistically whether these recent behaviors signal temporary deviations or permanent changes in components of the value premium. Using value premium data for July 1963 through June 2020, they find that:

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Size as Catalyst for Value and Momentum

The conventional size (market capitalization) premium is notoriously weak since discovery almost 40 years ago. Does this poor live track record mean it is useless to investors? In their September 2020 paper entitled “Settling the Size Matter”, David Blitz and Matthias Hanauer examine whether the size premium is exploitable as a standalone anomaly or in combination with other anomalies. They consider six versions of a size factor from prior research, as follows:

  1. Adjusted for value – average of three small-cap stock portfolios minus average of three big-cap stock portfolios after sorting for book-to-market ratio.
  2. Adjusted for value, investment and profitability – average of nine small-cap stock portfolios minus average of nine big-cap stock portfolios after separately sorting on the other three factors.
  3. Adjusted for profitability – average of three small-cap stock portfolios minus average of three big-cap stock portfolios after sorting for profitability.
  4. Adjusted for quality – average of three small-cap stock portfolios minus average of three big-cap stock portfolios after sorting for quality.
  5. Adjusted for quality beta – average of three small-cap stock portfolios minus average of three big-cap stock portfolios after sorting for quality beta.
  6. Adjusted for size, investment and return on equity – average of nine small-cap stock portfolios minus average of nine big-cap stock portfolios after separately sorting on the other three factors.

All factor portfolio segments are capitalization-weighted, and all returns are in U.S. dollars. They consider regressions (implying long-short implementations) and long-only sides of these factors. They also consider size factor definitions that do not overweight size inputs, as do those above. Using data required by these definitions for U.S. stocks since July 1963 (or January 1967 for some inputs) and for international stocks since July 1990 (or July 1993 for some inputs), all through December 2019, they find that: Keep Reading

Interest Rates and the Equity Value Premium

Do interest rate effects explain/predict the poor performance of value stocks over the past decade, and especially during 2017 through early 2020? In their May 2020 paper entitled “Value and Interest Rates: Are Rates to Blame for Value’s Torments?”, Thomas Maloney and Tobias Moskowitz investigate interactions between equity value factors and the interest rate environment. They first examine theoretical relationships and then explore relationships between several ways to measure the U.S. equity value premium and interest rates empirically, including interest rate level, change in short-term rates, change in long-term rates and slope of the yield curve. They look at subperiods and some international evidence. Finally, they assess ability of interest rate variables to predict the value premium and thereby inform factor timing strategies. Using U.S. interest rate and firm/stock data inputs for several ways of estimating the value premium as available since January 1954, and similar data for Japan, Germany and the UK since 1988, all through December 2019, they find that: Keep Reading

Investor Access to Factor Premiums via Funds

Are widely accepted equity factor exposures available in fact to investors via “smart beta” mutual funds and exchange-traded funds (ETF)? In their May 2020 paper entitled “Smart Beta Made Smart”, Andreas Johansson, Riccardo Sabbatucci and Andrea Tamoni test effectiveness of individual U.S. equity mutual funds and ETFs and combinations of these funds for exploiting several major equity risk factors (value, size, profitability and momentum). After assembling a sample of funds with names that indicate smart beta strategies, they iteratively (annually for size, value and profitability and daily for momentum):

  1. Apply a double-regression to each fund to identify those that are actually “closet” market index funds.
  2. Refine factor exposures of each true smart beta fund based on actual fund holdings.
  3. Construct separately for institutional and retail investors tradable long-side (mutual funds and ETFs) and short-side (ETFs only) risk factors via value-weighted combinations of the 10 funds with the strongest exposures to each factor.

Using daily, monthly, and quarterly data for U.S. equity mutual funds and ETFs with (1) names indicating smart beta strategies, (2) at least one year of returns and (3)assets over $1 billion, data for their individual component U.S. stocks and specified factor returns during January 2003 through May 2019, they find that: Keep Reading

Best Stock Portfolio Styles During and After Crashes

Are there equity styles that tend to perform relatively well during and after stock market crashes? In their April 2020 paper entitled “Equity Styles and the Spanish Flu”, Guido Baltussen and Pim van Vliet examine equity style returns around the Spanish Flu pandemic of 1918-1919 and five earlier deep U.S. stock market corrections (-20% to -25%) in 1907, 1903, 1893, 1884 and 1873. They construct three factors by:

  1. Separating stocks into halves based on market capitalization.
  2. Sorting the big half only into thirds based on dividend yield as a value proxy, 36-month past volatility or return from 12 months ago to one month ago. They focus on big stocks to avoid illiquidity concerns for the small half.
  3. Forming long-only, capitalization-weighted factor portfolios that hold the third of big stocks with the highest dividends (HighDiv), lowest past volatilities (Lowvol) or highest past returns (Mom).

They also test a multi-style strategy combining Lowvol, Mom and HighDiv criteria (Lowvol+) and a size factor calculated as capitalization-weighted returns for the small group (Small). Using data for all listed U.S. stocks during the selected crashes, they find that: Keep Reading

Divergence of Book Value from Actual Value?

Why do recent studies find that the value premium declines over time? In their April 2020 paper entitled “The Fundamental-to-Market Ratio and the Value Premium Decline”, Andrei Gonçalves and Gregory Leonard investigate whether book value (book equity, BE) is a good proxy for actual fundamental value (fundamental equity, FE). They measure FE for each firm at the end of June from accounting data as of the end of the prior calendar year as autoregression-estimated cash flow (payouts, including share buybacks) with a uniform discount rate across firms. They then sort stocks into tenths (deciles) based on BE-to-Market Equity ratio (BE/ME) or FE-to-Market Equity ratio (FE/ME) based on end-of-June stock prices. Finally, they annually reform capitalization-weighted portfolios that are long (short) the deciles with the highest (lowest) ratios to compare BE-based and FE-based value premiums. Using BE and FE inputs, market capitalizations and prices for all U.S.-listed common stocks except utilities and financials during July 1973 through June 2019, they find that:

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