QUANTITATIVE STRATEGIES: FACTOR INVESTING

The prolonged poor performance of the value factor has led to doubts about whether the value premium still exists. Some have noted that the observed returns still fall within statistical confidence intervals, but such arguments do not restore full confidence in the value premium. This article adds to the literature by showing that the academic value factor, HML, has not only suffered setbacks in recent years but has, in fact, been weak for decades already. However, the authors show that the value premium can be resurrected using insights that are well documented in the literature or common knowledge among practitioners. In particular, they include more powerful value metrics, apply some basic risk management, and make more effective use of the breadth of the liquid universe of stocks. Their enhanced value strategy also suffers in recent years, but this is largely explained by an extreme widening of valuation multiples similar to the late 1990s. The authors conclude that a solid value premium is still clearly present in the cross-section of stock returns. TOPICS Analysis of individual factors/risk premia, developed markets, emerging markets, factor-based models* Value investing is a classic concept. The 18th century mutual fund Concordia Res Parvae Crescunt stated that its aim was to “invest in solid securities and those that based on a decline in their price would merit speculation and could be purchased below their intrinsic values. ” Graham and Dodd (1934) are commonly credited with laying the intellectual foundation for modern-day value investing. Formal evidence for the existence of a value premium was provided by Basu (1977), Stattman (1980), Rosenberg, Reid, and Lanstein (1985), Jaffe, Keim, and Westerfield (1989), and Lakonishok, Shleifer, and Vishny (1994) using ratios such as earnings to 1 See the white paper “A Brief History of Robeco and the Mutual Fund Industry” by Jan Sytze Mosselaar, available at https://www.robeco.com. David Blitz is chief researcher at Robeco in Rotterdam, The Netherlands. d.c.blitz@robeco.com Matthias X. Hanauer is a senior researcher at Robeco in The Netherlands and a postdoctoral researcher at TU Munich in Munich, Germany. m.hanauer@robeco.com 2 | Resurrecting the Value Premium Quantitative Special Issue 2021 price (E/P), book value to market value (B/M), and cash flow to price (C/P) to classify stocks as either value or growth. Broad acceptance of the value effect followed after Fama and French (1992) thoroughly established the presence of a value premium in the US stock market and introduced the three-factor model (Fama and French 1993). The three-factor model augments the capital asset pricing model with a size factor, SMB, and a value factor, HML. The HML factor is a hypothetical long–short portfolio, which combines long positions in stocks with high B/M ratios with short positions in stocks with low B/M ratios. The three-factor model and its subsequent extensions have a central place in the asset pricing literature. The first serious doubts about the value premium arose during the tech bubble in the late 1990s. For a while, it seemed that valuations did not matter anymore, as expensive growth stocks massively outperformed cheap value stocks. However, the strong performance of growth stocks turned out to be driven by unsustainable multiple expansion, and the burst of this bubble in the early 2000s resulted in a strong comeback of the value factor (cf. Asness et al. 2000). A fresh challenge was posed by Houge and Loughran (2006), who found no evidence of a value premium for equity indexes, mutual funds, and large-cap stocks. The failure of popular value indexes to outperform their growth counterparts was also observed by Hsu (2014). Nevertheless, the value effect remained widely accepted, not only among academics but also among practitioners. Consequently, the value factor remains a key pillar of asset pricing models, many mutual funds are still dedicated to following a value investment style, and quantitative investors continue to make extensive use of value factors in their alpha forecasting models. Fresh doubts about the value factor have arisen in recent years, as the value premium has failed to materialize since the global financial crisis. With value stocks severely lagging growth stocks in the late 2010s and early 2020s, the factor is even being questioned existentially once again. Arnott et al. (2020), Fama and French (2020), and Israel, Laursen, and Richardson (2020) specifically attempted to refute the concern that the value premium might have disappeared permanently. Arnott et al. (2020) and Fama and French (2020) emphasized that, although the recent performance of the value factor is indeed disappointing, it still falls within the range of outcomes that can be expected based on regular statistical variation. In other words, the performance of value may have been bad, but investors should realize that capturing a premium in the long term can involve these kinds of drawdowns in the short term. To illustrate, there have also been periods of a decade, or longer, over which the equity premium failed to materialize. Israel, Laursen, and Richardson (2020) dismissed other arguments for why value might have stopped working, such as increased share repurchase activity, the growing importance of intangibles, the low-interest-rate environment related to central bank interventions, or simply because everyone knows about the strategy. Although these studies make valid points, they do not restore full confidence in the strength and robustness of the value effect. This article contributes to the existential debate about the value premium in two ways. First, we show that the academic value factor, HML, has not just suffered setbacks in recent years but has actually been struggling for decades. Based on the post-publication evidence, the concern that the HML value premium may have disappeared is not unreasonable. In fact, if today’s data had been available when Fama and French conducted their classic studies, it is conceivable that they would have deemed the evidence in support of the existence of a value premium to be insufficiently convincing. We also show that the CMA investment factor of Fama and French 2 A key argument made by Fama and French (2020) is that the hypothesis that the out-of-sample value premium is the same as the in-sample value premium cannot be rejected. Following the same logic, however, one could argue that the hypothesis that the in-sample premium is actually the same as the out-of-sample premium cannot be rejected either. Quantitative Special Issue 2021 The Journal of Portfolio Management | 3 (2015), which can be seen as an academic alternative to the classic HML factor, offers little improvement and has also been quite weak over the last three decades. Our main finding is that existential concerns about the value premium evaporate when considering a value investment strategy that is a bit more sophisticated than the generic HML approach. Although this enhanced value strategy also suffers in recent years, it has a solid long-term track record with a premium that is highly significant, both from an economical perspective and from a statistical perspective. Our resurrected value factor uses ideas that are well documented in the literature or common knowledge among practitioners. Most importantly, we use a composite of value metrics, apply some basic risk management, and make more effective use of the breadth of the liquid universe of stocks. We conclude that, with a little bit of effort, a healthy value premium can still be discerned in the cross section of stock returns. Thus, investors should not jump to the conclusion that the value premium has disappeared based merely on the weak performance of generic value strategies. Arnott et al. (2020) emphasized that the poor performance of generic value strategies in recent years stems from an extreme widening of valuation multiples. For our enhanced value strategy, we also observe that, toward the end of our sample, the spread in valuation multiples between growth stocks and value stocks reaches a level that was last seen at the height of the tech bubble in the late 1990s. This helps to understand why our enhanced value strategy is also not able to make it through the most recent years unscathed. However, it also implies that the true magnitude of the value premium may be underestimated with our sample period and that the forward-looking expected return on value versus growth stocks is currently higher than average. We note that, similar to the classic HML factor, our enhanced value factor remains a theoretical construct. In particular, we ignore various limits to arbitrage that investors face in reality, such as transaction costs, shorting costs, taxes, and long-only constraints. The scope of our article is limited to establishing that a highly significant value premium is still present in the cross section of stock returns, which is the first-order necessary condition for value investing. We fully acknowledge that more challenges need to be overcome to actually capture that premium in reality, as is the case for factor premiums in general. The outline of this article is as follows. We first review the performance of the classic HML value factor. Next, we conduct a similar analysis for the CMA investment factor, which can be seen as an academic alternative to HML. We then describe our more sophisticated value strategy. This is followed by an overview of the empirical performance of this alternative value factor. Finally, we conclude. GENERIC VALUE STRATEGIES The HML Value Premium We begin with reviewing the performance of the classic HML value factor of Fama and French (1993). The building blocks for HML are the 2 × 3 capitalization-weighted portfolios resulting from independently sorting on size and the B/M ratio, using the NYSE median market capitalization as the breakpoint for size (big versus small) and t