Value investing as a systematic strategy
Stocks that were cheap relative to their book value did better in the past than expensive ones. This value premium is one of the longest known anomalies in the stock market. But whether it really exists and how big it is has been hotly debated for years.
Unlike chart reading, this is about figures from the balance sheet and not the price history. The basic idea: stocks that are cheap relative to their balance sheet value, so called value stocks, used to do better than highly valued stocks, so called growth stocks.
The pattern became known through the economists Eugene Fama and Kenneth French, who described it systematically in 1992. From it they built a factor called HML, short for high minus low. It measures the difference in return between cheap and expensive stocks.
Vanguard founder John Bogle, however, doubted that this value premium would last and argued that the result depended heavily on the period chosen. The years that followed at first proved him right: from about 2007 to 2020, cheap stocks did clearly worse than expensive ones. The debate still isn't settled.
A newer development weakens the classic view further. In an extended model by Fama and French from 2015, which also takes into account how profitable a company is and how much it invests, the pure valuation factor loses much of its own explanatory power. Cheap stocks are often cheap, then, because the companies earn less, not because the market misprices them.
Fama and French (1992, 1993) showed that the ratio of book value to market value, together with a company's size, explains a large part of the differences in returns of American stocks. The older standard model, the CAPM, couldn't. In American data since 1926 the HML premium is usually given as three to five percent a year, though with large swings depending on the period.
Once again there are two camps on the explanation. Fama and French themselves think a high ratio of book value to market value shows a company is in trouble. So investors carry a real, higher risk and are paid for it. Behavioral researchers see it differently: investors expect too much from growth stocks, and those expectations are later disappointed.
Golubov and Konstantinidi (2019) and Jaffe and others (2019) split the valuation factor into two parts: one that measures mispricing and one that measures growth opportunities. Only the first predicts future returns. In the five factor model of Fama and French (2015), with profitability and investment as separate factors, HML's own contribution becomes much smaller. For practice this means: simply searching for stocks with a low price to book ratio without paying attention to how profitable the companies are falls short.
Summary
- Cheaply valued stocks did better on average than expensive ones over long periods.
- Whether this value premium is real and will last has been hotly debated for years.
- Much of the classic value premium can be explained by how profitable companies are and how much they invest.
Did you get it?
What does Fama and French's HML factor measure?
The difference in return between stocks with a high and a low ratio of book value to market value.
Which two explanations face off on the value premium?
One says cheap stocks carry higher risk and are paid for it, the other says investors expect too much from growth stocks.
What changes in Fama and French's five-factor model?
Profitability and investment are added as separate factors, and that makes the pure valuation factor's own contribution much smaller.
Sources and further reading
- Fama, E. F. and French, K. R. (1992), The Cross-Section of Expected Stock Returns, Journal of Finance
- Fama, E. F. and French, K. R. (1993), Common Risk Factors in the Returns on Stocks and Bonds, Journal of Financial Economics
- Fama, E. F. and French, K. R. (2015), A Five-Factor Asset Pricing Model, Journal of Financial Economics
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