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The poor long-term live performance of the first generation of value indices indicates that capturing the value premium is not easy. This does not mean, however, that the value premium is beyond the reach of investors. We argue that a value premium still exists, but that harvesting it requires an approach that is much more sophisticated than simply following a straightforward value index.
Once the value effect became known, it did not take long for index providers to introduce indices designed to harvest the value premium. A recent paper by Hsu (2014) finds that their performance has been disappointing. Over the last 10, 20 and 30 years the return of classic value indices is found to be in line with, or even slightly lagging the market. The same picture emerges from the online data library of Professor Kenneth French. In the Robeco research note “Factor strategies need breadth” we observe that the return difference between the Fama-French US large-cap value and growth portfolios has effectively been zero since the mid-1990s. Based on these findings investors might wonder if, perhaps, the value premium has disappeared.
There are various approaches towards successfully harvesting the value premium. The first three points relate to what fundamental investors like to call avoiding ‘value traps’. After this we will discuss the use of more effective valuation ratios and increasing the opportunity set of a value strategy.
Fama and French (1992) conjecture that the value premium might be a reward for the risk of financial distress, i.e. bankruptcy risk. Their value strategy, which selects stocks with high book-to-market ratios, indeed tends to pick up a disproportionately large number of financially distressed stocks. The mechanism behind this is that if a company gets into serious trouble, its share price and therefore also its market value will show a sharp decline, and because book values tend to be stickier, the typical result is that the stock becomes considerably more attractive based on its book-to-market ratio.
At Robeco we examined the relation between the value premium and distress risk extensively. The results are described in De Groot and Huij (2015). In a nutshell, we confirm that the Fama-French value strategy based on book-to-market brings along a significant bias towards financially distressed stocks. However, this correlation between financial distress and value does not imply causality. In fact, we find that the value premium is not concentrated in distressed stocks, but present among all stocks. In fact, it even appears to be a bit stronger among the most financially sound companies. The investment implication is that the value premium can be harvested more efficiently by avoiding financially distressed value stocks.
The more negative the recent return on a stock, the more attractive it tends to become on valuation measures. As a result, a portfolio of value stocks typically exhibits negative price momentum. This is an undesirable feature, because there is also abundant evidence for the existence of a momentum premium. Investors can prevent going against the momentum effect by avoiding value stocks with poor momentum and selecting value stocks with favorable momentum instead. In our research note “When factors disagree” we show that the performance of a value strategy is boosted significantly by following this simple idea
The average value stock not only exhibits above-average bankruptcy risk and below-average momentum, it also has below-average profitability, as shown by Novy-Marx (2013). He goes on to show that this is an undesirable feature, because there is also strong evidence for the existence of a profitability premium. Moreover, he finds that a generic value strategy can be enhanced significantly by avoiding value stocks with poor profitability and selecting ones with high profitability instead.
The value measure favored by academics such as Fama and French, the book-to-market ratio, is just one of many ways of measuring if a stock is cheap compared with its intrinsic value. Other measures are the price-to-sales ratio, the price-to-earnings (P/E) ratio and dividend yield. There can also be many variations on a specific measure. For instance, for the earnings in the P/E ratio one could take most recent realized earnings, next year’s expected earnings based on consensus analyst forecasts, or average earnings over the last ten years as in Shiller’s cyclically adjusted P/E (CAPE). A drawback of earnings-based valuation measures is sensitivity to accounting assumptions with regard to e.g. depreciation and amortization of goodwill, which may be addressed by using value measures based on cash-flow or operating profitability. Another drawback is that P/E ratios may be boosted by increasing the leverage of firms, which might be dealt with by using a measure of earnings before interest expenses compared with total firm value.
In recent years academic studies have begun to appear which examine the performance of some of these alternative valuation metrics. At Robeco we already analyzed dozens of different valuation measures more than a decade ago, and found that, indeed, some are much more effective and robust than others. The most powerful ones were selected for inclusion in our models, and their effectiveness has been confirmed by our live experience since then.
Whereas the Fama-French value factor ceased to be effective in the large-cap segment of the market since the mid-1990s, the same factor applied to the small-cap segment of the market shows no signs of deterioration. Investing in small-caps does have the drawback of poor liquidity, which limits the capacity of a small-cap value strategy. In order to increase the opportunity set for a value strategy, investors do not necessarily need to turn to small-caps though. It is also possible to make more effective use of value opportunities in the large-cap space, by preventing that a relatively small number of the very largest stocks dominate outcomes, which is what happens with the capitalization-weighted portfolios favored by Fama-French.
In the Robeco research note “Factor strategies need breadth” we observe that by simply applying equal-weighting instead of capitalization-weighting the return spread between US large-cap value and growth portfolios already changes from zero to positive over the last thirty years. These insights explain why we seek to combine the liquidity benefits of capitalization weighting with the opportunity benefits of equal weighting, and why we also include liquid off-benchmark mid- and small-cap stocks in the eligible universe of our factor strategies.
International diversification is another way to increase the opportunity set for a value strategy. The online data library of Professor Kenneth French also contains data for a value factor for developed equity markets excluding the US, with data starting in 1990. This international value factor shows a solid value premium, both within the large-cap segment and the small-cap segment of the market, and both using capitalization-weighting and equal-weighting. Fama-French do not cover emerging equity markets, but in our research we find that value factors have also been highly effective there. In short, global diversification helps to generate consistent returns with a value strategy.
At Robeco we incorporate all of these insights into our quantitative approach towards value investing, as we see merit in all of them. Our research illustrates the importance of making these enhancements. For instance, in a recent note titled “The beauty and the beast of value and momentum investing” we find that the return difference between the most and least attractive value stocks amounts to no less than 7% per annum. In our note “Efficient factor investing strategies” we directly compare the Robeco approach towards value investing with a popular smart beta (index) approach, and find a 4% higher return for the Robeco approach. That is the difference between a successful value strategy and a mediocre or outright ineffective one.