When does value investing work and how does it work best? In the April 2015 initial draft of their paper entitled “Fact, Fiction, and Value Investing”, Clifford Asness, Andrea Frazzini, Ronen Israel and Tobias Moskowitz address areas of confusion about value investing. They describe value as the tendency of cheap securities to outperform expensive ones based on some valuation method. They broadly specify the value premium as the return achieved by holding or overweighting cheap securities and shorting or underweighting expensive ones. They focus on systematic (mechanical), diversified value strategies based on quantified metrics such as book-to-market ratio or earnings-price ratio. Their context is firm belief that such strategies are great investments. Based on academic studies and simple tests with recent data, largely from Kenneth French’s data library, they conclude that:
- Fundamental stock indexing is attractive as a value strategy because it employs multiple value metrics, uses up-to-date prices when rebalancing and implicitly times the value premium by considering degree of relative stock valuation.
- Value investing works best in combination with other factors such as profitability, momentum and quality. For example, for hedge portfolios that are long (short) stocks with high (low) expected returns during July 1963 through December 2014, the gross annualized Sharpe ratio is:
- 0.46 for a value (book-to-market ratio) portfolio.
- 0.58 for a 60%-40% value-profitability portfolio.
- 0.79 for a 60%-40% value-momentum portfolio.
- 0.84 for an equally weighted value-momentum-profitability portfolio.
- Investors should view value and momentum as components of a system, strong alone but much stronger together due to their negative correlation.
- The value concept applies to asset classes other than equities. Example metrics include:
- Real yield (nominal yield minus expected inflation) for bonds.
- Deviations from purchasing power parity for currencies.
- No single value metric is demonstrably better than another. An average of multiple metrics is typically best because averaging helps reduce noise and avoid data snooping bias, thereby smoothing out-of-sample performance.
- During the 88 years through 2014, there is no statistically significant value premium (as conventionally measured) among large-capitalization U.S. stocks. However, value is still attractive for large stocks in combination with momentum. For example, the gross annualized Sharpe ratio for a 60%-40% value-momentum hedge portfolio is 0.65 among large-capitalization stocks, compared to 0.82 among small-capitalization stocks.
- The value premium likely derives from a combination of risk-based and behavioral explanations, both of which plausibly support premium persistence.
In summary, evidence supports belief in the effectiveness of systematic value investing, and especially the effectiveness of combining value and momentum strategies.
Cautions regarding conclusions include:
- Factor return measurements generally derive from hedge (long-short) portfolios that assume frictionless rebalancing and no shorting costs. Accounting for these costs, especially when rebalancing occurs monthly, would reduce reported returns. Moreover, shorting may not be feasible for some stocks. Use of net rather than gross returns may affect findings.
- Systematic, diversified factor portfolio management is beyond the reach of most investors. Delegating to a manager incurs fees that reduce returns.
