- A value stock has a low price
relative to some fundamental metric,
like book value or earnings.
The value premium is the excess return
that value stocks are expected to earn over the market.
This excess return has historically been
and is expected to continue to be positive.
In other words, value stocks have higher
expected returns than the market.
The out-performance of value stocks
was first documented in a 1985 paper
by Barr Rosenberg, Kenneth Reid, and Ronald Lanstein
with the provocative title
"Persuasive Evidence of Market Inefficiency".
They had observed that low priced stocks
had persistently higher risk adjusted returns
than they should in an efficient market.
I'm Ben Felix. Portfolio Manager at PWL Capital.
In this episode of Common Sense Investing,
I'm going to tell you
all that you need to know
about the value premium.
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Seven years after the 1985 paper
by Rosenberg, Reid and Lanstein,
Eugene Fama and Kenneth French
came out with a paper
that would forever change the study of asset pricing,
"The Cross-Section of Expected Stock Returns".
Fama and French's 1992 paper
took the empirical observations
of small cap and value stocks delivering higher returns
than their level of riskiness
relative to the market would predict,
and theorized that small cap and value stocks were exposed
to independent systematic risks,
separate from the risk of the market.
They went on to build
their now famous Fama French Three-Factor Model
for asset pricing
which includes the independent risks of the market,
small stocks and value stocks.
In 1992, Fama and French examined the 28 year data set
from July, 1963 to June, 1991 for U.S. stocks.
Over this time period,
there was a large
and statistically significant value premium,
with value stocks beating the market
by 4.9% per year on average,
that's a huge difference.
In the year 2000, Fama and French
used previously unavailable data
to examine the value premium from July, 1926 to June, 1963.
U.S. value stocks beat the U.S. market
by a smaller but still meaningful 2.39% per year
on average over this time period.
This should be compelling.
Value stocks had historically offered
an independent source of risk,
which has diversification benefits in a portfolio.
And they had offered a risk premium in excess of the market.
The U.S. value premium is well-documented
for the full period
leading up to Fama and French's 1992 paper.
But it is also well-documented
that anomalies in the financial markets
tend to disappear or decline once they've been published.
This is an important point
and it goes to the core of financial theory.
An observation like value stocks
beating the market historically,
is not helpful in isolation.
The observation becomes helpful
when there is a strong theoretical explanation for it.
The combination of empirical observations and theory
allows us to build predictions
about how things might be expected to behave in the future.
For example, if stocks that start with the letter A
outperformed the market for a given 28-year period,
there is no logical reason to believe
that the same would be true for the next 28-year period.
If, as Fama and French proposed,
value stocks have higher expected returns
because they are riskier,
We would not expect
the value premium to disappear post-publication.
Economic theory predicts that
riskier investments should demand higher expected returns.
There is also a theoretical explanation for the existence
of the value premium from behavioral economics.
Both the risk-based and behavioral explanations
for the value premium have strong empirical support.
From the risk perspective,
companies with lower prices tend to be under distress,
have high financial leverage,
and face substantial uncertainty in future earnings,
as documented by Nai-fu Chen and Fang Zhang
in their 1998 paper "Risk and Return Value Stocks".
And they tend to be much riskier than growth stocks
in bad economic times,
and only slightly less risky in good economic times,
as documented by Lu Zhang in his 2005 paper,
"The Value Premium".
These are real economic reasons
for investors to demand higher expected returns
for taking on more risk.
On the behavioral side, in their 2012 paper,
"Identifying Expectation Errors
In Value/Glamour Strategies:
A Fundamental Analysis Approach",
Joseph Piotrowski and Eric So
observed systematic pricing errors
causing value stocks to be under priced
and growth stocks to be overpriced.
For example, investors may be too optimistic
about the future growth prospects of a glamorous firm
like Apple or Tesla, irrationally bidding up their prices
and reducing their expected returns,
while neglecting value stocks,
increasing their expected returns.
Other biases like confirmation bias,
familiarity, anchoring, and loss aversion
could also explain
the persistent mispricing of value stocks.
On the surface, it might seem like a behavior-based
value premium would go away post-publication,
because investors would be expected to smarten up
once they realized their behavioral errors.
But behavioral biases do tend to be persistent,
even when we know about them.
There are also limits to arbitrage
that can make it really hard
for even the most disciplined rational investors
to take advantage of mispricings
caused by behavioral biases.
Think about the example of a pension investment officer
choosing between two funds.
One fund is expected to match the market's return
and never underperform,
while the other fund, maybe a value fund,
is expected to beat the market by 1% per year on average,
but it might have five
or even 10 year periods where it under-performs the market.
The pension investment officer likes her job
and wants to keep the pensioners happy,
so she is willing to give up
the higher expected returns of the value fund
to avoid the potential pain of under-performance.
This agency issue causes a limit to arbitrage
that will allow the mispricing of value stocks to persist.
So far, we have talked about historical data
for the value premium up to 1991,
and the theory behind why we expect to see
a positive value premium in the future.
But there's been a big problem since 1991.
The U.S. value premium has been much weaker
than it was in the past.
For the period from July, 1991 to June, 2019,
the value premium was an economically modest
1.17% per year on average,
and it was not statistically different from zero.
Fama and French came out with a new paper in January, 2020,
simply titled "The Value Premium",
where they ask, based on the weak post-publication data,
whether we can confidently conclude
that the U.S. value premium declined or even disappeared
following their 1992 paper.
They found that the high volatility
of monthly value premiums precludes us
from drawing any conclusions about a change
in the expected value premium based on this time period.
Not being able to reject the hypothesis
that out of sample expected premiums
are the same as in sample expected premiums,
sounds really nice,
but the last few years, even the last decade,
have been a bloodbath for U.S. value investors.
For the three years ending December, 2019,
value stocks trailed the market
by 6.88% per year, on average.
If that's not pain, I don't know what is.
For the decade ending December, 2019,
value stocks trailed the market
by 2.24% per year on average.
As painful as the recent history may have been
for any committed value investor,
periods like this should not be unexpected.
In their 2018 paper "Volatility Lessons",
Fama and French used Bootstrap
to simulate 100,000 time periods of varying length,
to estimate the probability
of the value premium being positive
over a given time period.
They found that over a 23 year period,
there was a 23% chance of a negative premium.
For a ten-year period,
they found a 9% chance of a negative premium.
We also have to remember
that while the value premium can trail the market
for long periods of time,
the market can similarly trail treasury bills
for a long period of time.
And here's the kicker.
Historically, there have been more ten-year periods
where the U.S. market delivered a negative premium,
than there have been ten-year periods
where U.S. value delivered a negative premium.
And guess what?
During some of those periods
where U.S. market delivered a negative premium,
U.S. value delivered a positive premium.
If that's not a diversification benefit,
I don't know what is.
This discussion is focused
on the U.S. value premium,
and whether we can still count on it
now that everyone knows that it exists.
There is strong theoretical basis.
Whether we take the risk-based or behavioral position,
to believe that a positive
expected value premium will persist.
Despite a run of relatively weak performance,
we can't conclude with any confidence
that the value premium has changed.
And even this recent period of extreme pain
falls well within what a value investor
should expect from time to time.
The recent weak performance of value
may have even created an opportunity.
I do not condone market timing or factor timing.
They are both very hard to do successfully.
Cliff Asness, the co-founder of AQR Capital
and a former student of Eugene Fama,
similarly discourages trying to time investment decisions,
most of the time.
Cliff has playfully referred to market and factor timing
as sins and suggests that investors
only sin a little and only in very specific cases.
Cliff wrote a research note in late 2019,
explaining that while factor timing
is not usually a good idea, the current value spread
makes a compelling case for sinning a little
by increasing your weight in value stocks.
The value spread is a tool that was created at AQR,
and it is used to measure the relative cheapness
of value stocks compared to history.
Using AQR's measure for value,
which includes controlling for things
like profitability and earnings quality,
as at August, 2019.
value was in the 97th percentile of historical cheapness.
And excluding the tech bubble,
it was as cheap as it has ever been by a fairly wide margin.
Unlike Cliff, I am not saying
that you should time a trade into value,
but I do think
that Cliff's point is applicable to anyone
who already has a longterm value tilt in their portfolio.
Despite the recent pain,
now might be the worst time to give up on value.
I've spent a lot of this video telling you
why we shouldn't give up on the U.S. value premium,
despite its relatively weak performance,
since it was publicized by Fama and French in 1992.
We always have to remember that while the headlines
tend to focus on the the U.S., the U.S. is not the world.
The experience of value investors in other countries
over the same time period has been very different.
From July, 1991 through June, 2019,
the same post-publication period
where we observed a declining U.S. value premium,
value stocks in Japan
beat the Japanese market by an annualized 6.14%.
Value stocks in the U.K. beat the U.K. market
by a more modest 0.29% annualized.
Emerging markets value beat the emerging markets
by an annualized 3.02%.
Asia Pacific value
beat the Asia Pacific market
by an annualized 5.4%.
Australian value beat the Australian market
by an annualized 2.95%.
And in a strange twist,
Canadian value trailed the Canadian market
by an annualized 0.53%.
Having a value tilt in a portfolio isn't for everyone.
It can be painful.
And it can be painful for long periods of time,
as we've seen.
For index investors, a value tilt also adds complexity
through the need to add additional value index funds
to a portfolio.
For anyone willing to live through a bit of pain,
and manage a bit of extra complexity,
We have seen that value stocks offer access
to a meaningfully positive expected average premium.
Recent history has been especially painful
for value investors,
but periods like this
are where the premium is ultimately earned
for those who stick with the strategy.
Thanks for watching.
My name is Ben Felix of PWL Capital,
and this is Common Sense Investing.
If you enjoyed this video,
please share it with someone
who you think could benefit from the information.
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