Do investors systematically undervalue stocks that have relatively large book-to-market fluctuations? In their December 2018 paper entitled “The Value Uncertainty Premium”, Turan Bali, Luca Del Viva, Menna El Hefnawy and Lenos Trigeorgis test whether book-to-market volatility relates positively to future returns. They specify book-to-market volatility as standard deviation of daily estimated book-to-market ratios divided by their average over the past 12 months. They estimate book value using the most recent quarterly balance sheet plus analyst forecasts of net income minus expected dividends since that quarter. They lag all accounting data three months and analyst forecasts one month to avoid look-ahead bias. They then each month starting January 1986 rank stocks into tenths (deciles) by book-to-market volatility and reform a hedge portfolio that is long (short) the highest (lowest) decile. Using monthly and daily returns and firm accounting data for a broad sample of non-financial U.S. stocks and data for a large set of control variables during January 1985 through December 2016, they find that:
- Stocks with high book-to-market volatility tend to have relatively:
- High market betas.
- Low market capitalizations.
- High book-to-market ratios (growth stocks).
- High investment (asset growth).
- High past-year price momentum.
- High idiosyncratic volatility and extreme returns (lottery stocks).
- Wide analyst earnings forecast dispersions.
- The value-weighted book-to-market volatility hedge portfolio generates:
- Average monthly gross return 0.95%.
- Gross monthly alphas across various factor models ranging from 0.61% to 1.10% per month. For example, gross monthly alpha versus a 7-factor model that accounts for market, size, book-to-market, investment, profitability, momentum and illiquidity factors generates gross monthly alpha 1.04% (about 12.5% annualized).
- The equal-weighted hedge portfolio exhibits stronger returns and alphas than the value-weighted portfolio.
- Outperformance of stocks with high book-to-market volatility drives hedge portfolio returns.
- Hedge portfolio return persists up to 12 months after portfolio formation.
- Regarding robustness of findings:
- Multivariate regressions confirm that findings are robust to controlling for a wide range of stock return/firm variables.
- Results for 1986-2000 and 2001-2016 subperiods are consistent.
- Findings hold after excluding small, illiquid or high idiosyncratic volatility stocks.
- Averaged across stocks, book-to-market volatility exhibits strong relationships with economic variables and significantly predicts overall stock market return and volatility.
In summary, evidence indicates that stocks with high daily book-to-market volatility relative to average book-to-market value over the past year tend to outperform other stocks.
Cautions regarding findings include:
- All findings are gross, not net. Although findings are robust to exclusion of stocks that are likely most costly to trade and hardest to short, hedge portfolio trading frictions and shorting costs/constraints may still be substantial.
- Average returns and alphas are insufficient to motivate a trading strategy. For example, the hedge portfolio may suffer crashes.
- Data collection, calculations and portfolio management are beyond the reach of most investors, who would bear fees for delegating to a fund manager.
