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Restoring the battered Value factor in equities

Restoring the battered Value factor in equities

20-10-2020 | インサイト

The recent dreadful performance of the academic Value equity factor has been a blow for many investors. Even prominent quants seem to have thrown in the towel on Value and factor investing quant in general.1 But are recent developments really enough to dismiss the Value factor altogether? We don’t think so.

  • David Blitz
    David
    Blitz
    Chief Researcher
  • Matthias Hanauer
    Matthias
    Hanauer
    Researcher

Speed read

  • The Fama-French definition of Value is too simplistic 
  • This does not mean the Value factor should be dismissed 
  • We propose a more sophisticated approach to Value investing 

For one, the recent poor performance of Fama-French style value stocks still falls within the statistical range of possible outcomes. And while it is true that classic value strategies performed poorly in equity markets, this has clearly not been the case for other asset classes. In corporate bond markets, for instance, value has been a clear source of outperformance over the past five years. 

Admittedly, such arguments do not fully alleviate concerns that the value equity factor may be impaired, or perhaps even obsolete. This is why, in a new study,2 we address this concern. We show that the classic definition of value can be resurrected by adopting a more sophisticated approach, which, in turn, enhances the academic approach.  

While most investors have focused on the most recent period of underperformance, we have found that the standard Fama-French value factor, based on book-to-market metrics, has not only suffered setbacks in recent years, but has been struggling for decades. This is consistent with the widespread view among academics that the classic value equity factor is now outmoded.  

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More powerful Value metrics

Our research shows that using more powerful value metrics, applying basic risk management techniques and using the breadth of the liquid universe of stocks more effectively, leads to much better investment results. Although this improved value strategy has also suffered in recent years, it has a solid long-term track record that does not warrant existing concerns. 

More specifically, we augment the book-to-market ratio with three alternative value signals namely: Ebitda/EV,3 cashflow-to-price and net payout yield. These three metrics all have in common that they do not rely on balance sheet information, such as book-to-market, but are based on earnings and cashflows and therefore less sensitive to accounting assumptions. 

We augment the book-to-market ratio with three alternative value signals

In terms of risk management, we seek to avoid the large persistent industry or regional bets that the standard value factor takes, given that certain industries and regions are structurally cheaper than others. We are therefore region and industry neutral in developed markets. In emerging markets, we apply country neutrality, as countries are the primary risk factor in these markets. 

Finally, we strive to make full use of the breadth the global equity market offers. The standard value factor gives a disproportionately high weight of 50% to small-cap stocks, which only comprise 10% of total market capitalization. At the same time, it also uses capitalization-weighting to prevent these numerous and extremely small stocks from dominating the result. 

However, this approach does not prevent overexposure to a small group of very large caps, nor does it fully remove smaller illiquid stocks from the universe. Our approach addresses these issues by focusing solely on the liquid large and mid-cap stocks, while using an equally-weighted allocation scheme to make full use of the breadth this universe of liquid stocks has to offer. 

Ultimately, our more sophisticated value equity factor uses ideas that have been well documented in the literature or that are common knowledge among practitioners. We therefore conclude that, with a bit of effort, a significant value premium can still be found in the cross-section of stock returns. 

Read the related working paper on SSRN.  

1See: Brown, A., “Anti-Quant Investing Manifesto Misses the Mark”, Bloomberg, 6 October 2020.
2Blitz, D. C., Hanauer, M. X., 2020, “Resurrecting the value premium”, working paper.
3Ebitda = earnings before interest, taxes, depreciations and amortizations, EV = enterprise value = market capitalization + net debt.

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