THE EXPECTED RETURN OF THE VALUE PREMIUM……

Summary

  • In their latest paper, Fama and French examine whether the recent lower returns to the value premium mean that its expected return has changed and conclude that it is within the range of what might be expected by chance.
  • A further study by Arnott et al. also investigates the issue and, similar to our previous analysis on this, conclude that the higher return of growth stocks is mainly due to their increased valuation level.
  • At the end of the decade, growth stocks traded at a substantial premium to value, likely creating a tailwind for the future relative returns of value stocks.

A previous note of ours looked at the question “Where has the Value premium gone” (here). There have been many similar research notes circulating on this topic. Two interesting recent contributions come from Fama and French, who studied the value effect in their landmark paper in 19921, and Arnott et al. 2019, some of whom work at Research Affiliates.In the latest paper by Fama and French, “The Value Premium”2, the authors examine the question whether the expected value premium (which they define here as the difference between value portfolio returns and a market-weighted portfolio) declines or even disappears entirely after the period they originally studied between 1963 to 1991 (their “in-sample” period). For example, during this period, value stocks across the US market (large and small) returned 0.42% per month with a t-statistic of 3.31 i.e. a highly statistically significant result. This (amongst other such studies) is a key reason why researchers and practitioners consider value to be an important return factor in equity markets. Since then however, returns to value stocks have been lower. In the period 1991 to 2019 the market-wide value premium was just 0.11% per month (t-stat 0.60), much lower than in the first period. Over the full period up to 2019, the corresponding return premium was 0.26% (t-stat 2.37)) – still a statistically significant result. The issue is whether we can say that the premium is meaningfully lower in the period since 1991 (their “out-of-sample” period) and that the expected premium is also lower.

Fama and French note that the spread in book-to-market (B/M), i.e. the difference in the respective B/M ratios of value and growth portfolios, has declined over the two periods. They also show a statistically significant relationship between the prior B/M spread and the value premium each month over the full period. Since on average the spread has declined in the post-1991 period, that explains some of the decline in the value premium. However, they caution that in their analysis, the remaining volatility of the value premium is high after controlling for the B/M spread. Hence, they state “the high volatility of monthly value premiums clouds inferences about whether the declines in average premiums reflect changes in expected premiums.” Moreover, they state that there is insufficient statistical evidence to argue that the expected value premium in the latter period is any different from what it was in the first “in-sample” period. So, from this analysis, there is no reliable evidence to argue that the expected return of the value factor may be lower going forward – although it does not exclude the possibility that it might be. As French whimsically comments here: “There are a lot of questions one would like to know the answer to, but you just can’t tell…If I get to ask God a question, I’m probably not going to ask this one.”

The second paper mentioned above takes a different perspective on the issue and provides a stronger case for why we might argue that the value premium is likely to reassert itself in the future. Among the authors are Robert Arnott and Campbell Harvey. By way of background, Robert Arnott is a distinguished quantitative practitioner and founder of Research Affiliates where he and his colleagues developed the value-oriented Fundamental IndexTM strategy. Campbell Harvey is a highly regarded academic at Duke University who has also recently written a well-known critique on the academic proliferation of factors and recommends setting the bar much higher before recognising a factor as having statistical validity.

In their paper “Reports of Value’s Death May Be Greatly Exaggerated”3, the authors examine various reasons for why the value premium has been negative in the period after the Global Financial Crisis (GFC), which they take as mid-2007, compared to the period before (from 1963). Among other issues, they investigate whether there is evidence that a/ investors have crowded into value stocks, potentially diminishing the premium going forward; b/ there is less migration from value to growth (an important source of the value premium historically); c/ there has been a change is the profitability of either value or growth stocks to the detriment of value and/or benefit of growth stocks. In a careful analysis, the authors decompose the difference in returns between value and growth stocks into three components:

  • Revaluation – the change in the relative price-to-book (P/B, which is just the inverse of B/M) valuation between value and growth. As our own analysis shows, and is confirmed in this paper, there is a very strong relation between the change in the relative valuation of value and growth stocks and the return of the value factor.
  • Profitability – the difference in profitability between value and growth stocks. Growth stocks are generally more profitable than value stocks and can sustain that advantage for many years after portfolio formation. A change in relative profitability could undermine the value premium.
  • Migration – the way that value (or growth) stocks in one period migrate to being neutral or growth (or value) stocks subsequently. As Fama and French showed in their paper on this4, migration is a substantial source of the value premium: as the prospects of some value stocks improve, their prices go up and so do their P/B ratios and so they move up to neutral or growth; similarly, some growth stocks fall to lower price levels, thus migrating to either neutral or value.

The migration and profitability components are central to the value premium. On average, the returns associated with migration exceed those of the returns linked to profitability differences. However, the effect of the revaluation of value and growth portfolios will buffet their relative returns from period to period and is a considerable source of risk – as is currently in evidence – since it can trend in one direction for extended periods (see the dotted line in the last chart below). Revaluation cannot persist for ever otherwise there would be an excessive bubble in growth stocks that would eventually revert.

Subtracting the revaluation component gives what the authors call the “structural” component of the value premium which comprises the profitability and migration components. In their analysis, they show that both components are similar in the post- 2007 period compared to their respective levels in the period before the GFC. As before, the migration component is stronger than the profitability component. In fact, the revaluation effect explains more than 100% of the difference in returns between value and growth stocks since 2007 mainly because growth stocks have become more expensive. This is clearly not an outcome driven by investors crowding into value stocks – quite the opposite and, if anything, seems to reflect herding into stocks with high growth opportunities. This is not to say that growth stocks will not deliver higher profits compared to value stocks in the future, they almost surely will. However, they are priced at a level that reflects that and more. History shows that they eventually revert from these elevated levels.

They note that a reversal of the value spread would provide a benefit to the value premium just as its recent widening has detracted from it. However, they also stress that, even if the valuation spread stayed the same, value stocks have an in-built advantage since the “structural” component of the value premium is robustly positive. Of course, the last time the value spread was this elevated, it peaked at a higher level still.

Another topic that Arnott et al. examine in their paper is whether price-to-book is still meaningful as a metric of value, especially as we have moved into an information and technology driven economy. They suggest that it makes sense to incorporate intangibles when considering the fundamentals of companies. At the least they support the use of other metrics other than just book-to-market when evaluating whether companies are value or growth. We will revisit this issue in a subsequent post.

Below we update the charts we showed before that show the relative returns of value and growth stocks globally. The details of portfolio construction are in the notes at the end5. A chart of the returns is shown in the figure below as the growth of £1 invested in each portfolio. Note that the period covered in our charts below only covers the later of the two periods that Fama French consider, as we do not have data for globaldeveloped markets going back to the 1960’s.

To track the relative returns of value vs. growth, each month we subtract the return of the global growth portfolio from the global value portfolio, and we cumulate that sum through time as shown in the chart below.

The third chart below shows the P/B ratio of the growth and value portfolios constructed as above as well as that of the overall market, all as solid lines using the left-hand scale. Note that, as Arnott et al. also show, the relative P/B level of growth vs. value has been climbing since 2007. At the end of 2019, using our portfolio construction procedure, growth stocks traded at a P/B level of 10.59 vs 1.19 for value, and therefore the ratio of their respective P/B levels was 8.92 – a level last reached in 2000.

Even a relatively limited reversal of the valuation spread between value and growth stocks should provide a benefit to the future relative returns of value stocks. However, there’s no telling when such a reversal could occur, or how much wider the spread could get in the meantime.

Have a great week

Garrett Quigley, Partner, Global Systematic Investors

Sources: 

  • Fama, Eugene F., and Kenneth R. French, 1992. The Cross-Section of Expected Stock Returns. Journal of Finance, vol. 47, no. 2, p427-465.
  • 2 Fama, Eugene F., and Kenneth R. French 2020. The Value Premium https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3525096
  • 3 Robert D. Arnott, Campbell R. Harvey, Vitali Kalesnik and Juhani T. Linnainmaa, 2020. Reports of Value’s Death May Be Greatly Exaggerated. Available at: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3488748
  • 4 Fama, Eugene F., and Kenneth R. French 2007. Migration. Financial Analysts Journal, Vol. 63, No. 3, p48-58.
  • 5 For our returns and characteristics data, we use a well-known source of independent data provided by Style Analytics. Using their analysis tools, we create portfolios based on book-to-market (B/M), which is a standard metric for sorting stocks on value-versus-growth, and then track the returns and characteristics of these simulated portfolios through time. For our purposes here, we create global portfolios where we capture the top 30% (value) and the bottom 30% (growth) by market value of stocks when ranked by B/M. We set the country weights in each portfolio to match their market weights in a broad index. We also exclude the bottom 5% of each market to avoid any potential distortions due to micro-cap stocks. All returns are in UK sterling. We start the portfolios at the end of 1989 (if we go further back than this, the data coverage declines).

In other news...

IMPORTANT INFORMATION

You must submit your agreement before access to the site can be granted. Important information regarding our Cookie Policy can also be found here

SCROLL TO READ

October 2022

 

This website is directed at institutional clients and individuals who have taken appropriate professional advice, who possess the necessary experience, knowledge and expertise to make their investment decisions and properly assess the risk that it incurs.

Gemini Capital Management (Ireland) Limited (“GemCap”), trading as GemCap, is a limited liability company registered under the registered number 579677 under Irish law pursuant to the Companies Act 2014 which is regulated by the Central Bank of Ireland, reference number C155302. Its principal office is at Ground Floor, 118 Rock Rd, Booterstown, Co. Dublin, A94 V0Y7 and its registered office is at 7th Floor, Block A, One Park Place, Upper Hatch Street, Dublin 2, Ireland.

GemCap acts as management company and global distributor to GemCap Investment Funds (Ireland) plc (“UCITS”).

GemCap Investment Funds (Ireland) plc is an umbrella fund with segregated liability between sub-funds incorporated as an investment company with variable capital registered under the registered number 485081 under Irish law pursuant to the Companies Act 2014 and authorised by the Central Bank of Ireland, reference number C67292, pursuant to the European Communities (Undertakings for Collective Investment in Transferable Securities) Regulations 2011 (as amended) ), having its registered office at 7th Floor, Block A, One Park Place, Upper Hatch Street, Dublin 2, Ireland(“the Fund”) .

The contents of this site have been prepared solely for information purposes and is not intended for distribution to, or use by, any person or entity in any jurisdiction or country where such distribution or use would be contrary to law or regulation. GemCap and the Fund does not give or make any guarantee, representation, warranty or other promise or confirmation (whether express or implied) as to its accuracy or completeness.

 

Risk Warnings

Please remember that the value of investments and the income from them can fluctuate (this may partly be the result of exchange rate fluctuations) and you may not get back the full amount invested. Past performance may not a reliable guide to future performance. A comprehensive list of risk factors is detailed in the Prospectus and the key investor information document (“KIID”) and an investment should not be contemplated until the risks are fully considered. The Prospectus and KIID can be viewed at www.geminicapital.ie

GemCap does not provide financial, investment, tax or any other professional advice in any way and none of the information on this site should be construed as such. None of the information contained on this site constitutes an offer to buy or sell or a solicitation, recommendation, invitation by or on behalf of GemCap to buy or sell any security, product, service or investment. Any opinions expressed on this site do not constitute investment advice and independent advice should be sought where appropriate. The view and/or opinions expressed by GemCap through this or any other platform, may be subject to change.

The shares in the Fund have not been and will not be registered under the US Securities Act of 1933 (the “1933 Act”) as amended or the securities laws of any of the states of the United States. The Shares may not be offered, sold, transferred, pledged or delivered, directly or indirectly, in or into the United States or to or for the account or benefit of any US Person except pursuant to an exemption from, or in a transaction not subject to the registration requirements of the 1933 Act and any applicable state laws, nor in any jurisdiction in which the Fund is not authorised to be publicly sold. The Fund is available only in jurisdictions where their promotion and sale are permitted.

The information contained on the website may not be redistributed directly or indirectly to any citizen or resident of the United States or any other jurisdiction where its distribution may be restricted by law. It is the responsibility of persons accessing the website to ensure compliance with the above.

 

Disclaimer for Investors in Switzerland

The Fund and its sub-funds, Calamos Global Convertible Fund and Third Avenue Real Estate Value Fund has been approved by the Swiss Financial Market Supervisory Authority FINMA (“FINMA”) for offering to Swiss non-qualified investors.

This website may contain advertising.

In Switzerland, the representative is ACOLIN Fund Services AG, Leutschenbachstrasse 50, CH-8050 Zurich, whilst the paying agent is Banque Cantonale Vaudoise, Place St.-François 14, CH-1003 Lusanne.

Swiss investors may obtain free of charge from the representative in Switzerland, the relevant fund documents, namely the prospectus, the key investor information documents, the articles of association, as well as the annual and semi-annual reports.

Past performance results are no indication of future results. Issuance and redemption commissions are not included in the performance figures. Performance results referring to a period of less than twelve months (year-to-date-performance, start of investment fund within the last twelve months) are no reliable indicator for future results due to the short comparison period.

 

Additional information for Qualified Investors in Switzerland:

The below-mentioned investment funds, which are also disclosed on this website, are neither registered with FINMA nor under contract for representation to Swiss investors. These investment funds may not be distributed neither to Swiss non-qualified and qualified investors nor exclusively to Swiss qualified investors:

 

GemCap Investment Funds (Ireland) Plc

Atlantic House Defined Returns Fund

Atlantic House Global Defined Returns Fund

Atlantic House Total Return Fund

Atlantic House US Enhanced Equity Fund

Atlantic House Uncorrelated Strategies Fund

Calamos Global Convertible Fund

Calamos Growth and Income Fund

Causeway Defined Growth Fund

GSI Global Sustainable Value Fund

GSI Global Sustainable Focused Value Fund

London & Capital Global Balanced Fixed Income Fund

London & Capital Global Conservative Fixed Income Fund

London & Capital Global Defensive Equity Fund (this Fund has terminated and accordingly, Shares in this Fund are no longer available for investment)

London & Capital Global Growth Fund

London & Capital Global Growth Fixed Income Fund

London & Capital Global Star Equity Fund

London & Capital Global Balanced Fund

London & Capital Global Equity Opportunities Fund

Principal Asset Allocation Fund

Semper Total Return Fund

TEAM International Equity Fund

Third Avenue Real Estate Value Fund

 

Legal

This GemCap website and material contained herein (including information from third parties) is provided ‘as is’, without any representation or endorsement made and without warranty of any kind whether express or implied, including, but not limited to, the implied warranties of satisfactory quality, fitness for a particular purpose, non-infringement, compatibility, security, completeness and accuracy.

By entering this site, you acknowledge and agree that the use of this site is at your own risk and to the extent permissible by applicable law, in no circumstances, including (but not limited to) negligence, shall GemCap be liable for any direct, indirect, incidental, special, consequential, or punitive damages, losses, costs or expenses nor for any loss of profit that results from the use of, or inability to use this site or any material on any site linked to this site (including but not limited to any viruses or any other errors or defects or failures in computer transmissions or network communications) even if we have been advised of the possibility of such damage. In addition, no liability can be accepted by GemCap in respect of any changes made to the content of this site by unauthorised third parties. All express or implied warranties or representations are excluded to the fullest extent permissible by law. We do not warrant that this site does not infringe any intellectual property rights of third parties.

No data transmission over the internet can be guaranteed as totally secure. Whilst GemCap strives to protect such information and every effort has been made to implement security protocols, in line with relevant legislation to ensure safe processing and storage of any data transmitted, we do not guarantee and cannot ensure the security of any information which you transmit to us. Accordingly, any information which you transmit to us is transmitted at your own risk.

The GemCap website is not a substitute for independent professional advice and users should obtain any appropriate professional advice relevant to their particular circumstances.

The information on this site is issued by GemCap.

 

Cookies

If you use the internet quite a bit, there’s a good chance you’ve heard of cookies.

But what are they?

Also known as HTML cookies, tracking cookies or magic cookies, these tiny files are automatically downloaded by your computer when you’re browsing online. Don’t worry – they’re perfectly safe. But we’d still like to take a moment to explain what cookies do, which ones we use and how to remove them – if you really want to.

Are Cookies Safe?

Yes, cookies are safe. The information they collect is completely anonymous. We never, ever, collect personal information using cookies. What’s more, cookies are not harmful to your computer, they take up minimal space and they can be removed with just a few clicks.

GemCap’s Cookie Functionality

  • Cookies provide enhanced functionality and speed to our site
  • These cookies help us to recognise your computer when you visit Gemini-Capital.ie and enable us to improve your visits to our website
  • Cookies assist us in identifying what kind of visitor/user you are, for us to provide you with the most relevant content

How Can I Remove Cookies?

Most computers are set to download cookies automatically, so if you’re happy with everything you’ve read, simply carry on as you were. However, if you’re at all concerned about having cookies on your computer, deleting them is simple.

Show me how to remove cookies

Likewise, you can also change your computer settings so that it won’t download any more cookies.

Show me how to change my cookie settings

The information on this site is issued by Gemini Capital Management (Ireland) Ltd, which is registered in Ireland No. 579677. The registered address for the company is 7th Floor, Block A, One Park Place, Upper Hatch Street, Dublin 2, Ireland.

For further information on our use of personal data collected and stored by the firm and its approved vendors, please see our Data Protection Statement, which can be found in the “Our Policies” section on this website.