Factor Investing Part 3 - Value Factor
If I asked you to name the most famous investor you know, who would it be? There is a very good chance you will say Warren Buffett. And for good reason.
Warren Buffett is one of the most successful investors of all time. From 1976 through 2017, his conglomerate Berkshire Hathaway outperformed the S&P 500 by about 11% per year. A dollar invested in Berkshire Hathaway stock in 1976 was worth $3,685 in March of 2017. A stunning track record. Add to that Warren’s folksy charm, frugal lifestyle, contributions to charity, and his wonderful story-telling abilities - it is easy to admire the man and his accomplishments.
Warren Buffett may also be the worlds most famous “value investor”. Value investing is a style that favours securities that are priced low relatively to some underlying characteristic. A value stock could be one that is priced low relative to its cash-flow, its book value (its assets minus its liabilities), or its sales. Warren described his early value stock picks as “cigar butts” - stocks of companies that were so distressed that their total outstanding stock value was actually worth less than the book value of the company. His style has evolved since those early years, but his philosophy has remained intact. His strategy is to buy stocks of quality companies at relatively low prices and hold onto them for a long time.
Naturally, Warren Buffett is often held up as the counterargument to those who advocate for low-cost, index-style investing. Why should I invest in index funds if Warren Buffett doesn’t? If the market is efficient, how can you explain the success of Warren Buffett?
This question was answered in a paper titled “Buffett s Alpha.pdf”, published in the 2018 Financial Analysts Journal. In the paper the authors looked at Buffett’s past performance to see how much of it could be explained by known factors, including market beta, the size factor, the value factor, and several others. If Buffett’s performance can be explained by exposure to academic risk factors it can, in theory, be replicated.
The results were eye-opening. "Buffett's Alpha" was largely able to be explained by exposure to value stocks and quality stocks (profitable stocks), plus the application of leverage and the availability of cheap investment capital or "float" from Berkshire Hathaway's insurance operations. The paper concludes in part as follows: “Our findings suggest that Buffett’s success is neither luck nor magic but is a reward for a successful implementation of value and quality exposures that have historically produced high returns.”
This does not in any way detract from Warren's accomplishments. With the benefit of hindsight, we can identify that Warren was a "factor investor" before anyone knew what factor investing was. He had the conviction and discipline to stick with his investing style through some very difficult periods. The practical implications for today's every-day investor, however, are great. While we may not be able to replicate his unique skills, we can replicate his value investing style in a systemized and low-cost way.
Let's dig into the value factor - what it is, how it has performed, and what that means for investors.
Introducing the Value Factor
We also established in Part 2 that the CAPM model for asset pricing was a useful but incomplete model. The differences in returns of diversified portfolios could be explained only partly by exposure to Beta. We took another step towards a better model with the introduction of the size premium, which showed us that relatively small stocks tended to outperform relatively large stocks over long periods of time. The third "leg of the stool" in this case is the value premium. That is - relatively cheap stocks tend to outperform relatively expensive stocks over long periods of time.
A 1992 paper written by Professor Eugene Fama and Professor Kenneth French titled "The Cross Section of Expected Stock Returns" explained these three factors all together at once. The main conclusion of the paper was that, while CAPM could explain about 2/3 of the differences in returns of diversified portfolios, by adding size and value factors into a three-factor model, we could now account for over 90% of the differences in returns between diversified portfolios.
This was a major breakthrough. To demonstrate just how big of a breakthrough this is, let's go back to our earlier example from Part 2. If Portfolio A returned 10 percent, and Portfolio B returned 13 percent, the difference in Market Beta between the two portfolios would explain 2 of the 3 percentage points of difference. With the addition of the size and value factors in the Fama-French 3-factor model, we could now explain 2.7 of the 3 percentage points of the difference in returns.
Value Factor in the Data
Now we will examine the value factor premium - or the excess return - that investors experienced by being exposed to the value factor. We simply subtract the return of relatively expensive stocks (also known as "growth" stocks), rom the return of cheap stocks (value stocks) to determine if a premium exists. For example, if the long term return of value stocks is 12% and the long term return of growth stocks is 10%, the value "premium" would be 2% (10%-12%).
So, how has the value factor performed empirically?
All charts and data are from Dimensional Fund Advisors.
In Canada, between 1977 and 2021, value stocks have outperformed growth stocks in 55% of one-year periods, 71% of 5-year periods, and 86% of 10-year periods since 1977, resulting in a value premium of 2.55% per year over that period.
1 Year Value Factor Premiums - Canada
Value Factor Outperformance Over Different Time Periods - Canada
In the US, between 1926 and 2021, value stocks have outperformed growth stocks in 59% of 1-year periods, 71% of 5-year periods, and 80% of 10-year periods since 1926 - resulting in a 2.84% average annualized value premium over that period.
1 Year Value Factor Premiums - US
Value Factor Outperformance Over Different Time Periods - US
Internationally (ex-US), between 1975 and 2021, value stocks have outperformed growth stocks in 59% of 1-year periods, 71% of 5-year periods, and 80% of 10-year periods resulting in a 4.09% average annualized value premium over that time period.
1 Year Value Factor Premiums - ex-US
Value Factor Outperformance Over Different Time Periods - International (ex-US)
Thoughts on the Value Factor
The value factor has had positive returns in the historical data in Canada, the US, and Internationally. It passes the tests of being persistent and pervasive. The value factor is also investible in most developed countries, with a wide range of index-tracking ETF's and mutual funds that will give an investor access to a diversified basket of value stocks.
Once again, we turn our attention to the question - why does the value factor, and the associated premium exist? What is it about relatively cheaper value stocks that make them riskier? Why do they produce higher returns than growth stocks over long periods of time.
I like to use this example. Let's take 2 companies - we will call them ABC Co. and XYZ Co.
ABC Co. and XYZ Co. both operate in the same industry. They have the same number of plants, inventories, and employees. They target similar clients and have similar sales. Now imagine that ABC Co. is trading for $15 per share while XYZ Co. is trading for $13 per share. What can explain the difference in the prices of these 2 securities? We already know that, qualitatively, these companies are nearly identical.
So, perhaps there is something else that is making XYZ Co riskier than ABC Co. It could be that:
- XYZ Co. just cut its dividend
- XYZ Co. has a high ratio of debt to its equity
- XYZ Co. has had inconsistent financial results
In short - there is something about XYZ Co. that makes owning their stock riskier than owning ABC Co.'s stock. It stands to reason that investors will pay a lower price/demand a higher return for owning XYZ-like stocks (value stocks), than they will for owning ABC-like stocks (growth stocks).
Another explanation for pricing of value stocks vs. growth stocks is that investors are often too optimistic in their expectations for the performance of growth companies and too pessimistic in their expectations for value companies. In other words, people tend to overvalue what they view as a "quality" company, and tend to "shun" what they view as a risky or bad company.
The additional risk of holding value companies can be observed in the data as well. The volatility, measured by standard deviation, of US Value stocks was 24.98 compared with 18.52 for US Growth stocks between 1926 and today.
Char Source: DFA Returns Web
Once again the value factor demonstrates that investors who pursue more risk in a diversified portfolio will demand higher returns for doing so. The risk factors that we have identified so far are:
1. Market risk - the higher risks we take and returns we expect from holding stocks vs. holding treasury bills over long periods of time
2. Size risk - the higher risks that we take and returns we expect from favouring smaller company stocks vs. larger company stocks over long periods of time.
3. Relative price risk - the higher risk that we take and returns expected for favouring relatively cheap stocks vs. relatively expensive stocks over the long run.
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Thanks for reading!
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