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45. Factor Investing 101 - Part 2: Value Premium and Profitability Premium Thumbnail

45. Factor Investing 101 - Part 2: Value Premium and Profitability Premium

Investing

Retire Me – Episode 45

Hello and welcome to Episode 45 of Retire Me!

This week we continue our deep dive into factor investing.   Last week we started with Market Beta and Small Cap Premiums.  This week, we will go into the Value Premium and the Profitability Premium.

As a quick refresher, a factor is a unique source of risk in a portfolio.  We want to pursue risk to generate higher returns, and we want to diversify our sources of risk so that we lower our volatility (smooth out our ride), because not all factors work all of the time.  In fact, they frequently go through periods where they don’t work.

Before we dive into this week’s factors, a quick reminder about what makes for a good factor, and the lens that we will use to go through the factors today:

  1. Has to deliver positive returns
  2. Has to be persistent across different periods of time and economic regimes
  3. Has to be pervasive – holds across countries and regions
  4. Has to be robust – holds up to various different measurements and definitions
  5. Has to be investible
  6. Has to be sensible – has a risk-based and behaviour based definition.  Ie. the aunt who wins the NCAA pool by picking all teams with red uniforms, or for an animal 

So this week, we will discuss the value premium and the profitability premium.  Next week we will go through the premiums in fixed income (bonds).  The week after that, we will go through portfolio construction and wrap up with my thoughts about who should and who shouldn’t invest in a factor portfolio.  

The week after that is the week of April 19th.   The government announced the release of the federal budget that day, so the week of April 19th, I will go through a summary of the budget with a special focus on how it will impact retirement savers and retirees.

Value Premium:

  • As we discussed last week, the 1992 paper “cross-section of expected stock returns” resulted in the development of the Fama-French 3 factor model
  • This model added the size and value factors to the market beta factor, taking the explanatory power of these factors from about 65% up to over 90%
  • So now, we will discuss the value factor
  • Value factor – relatively cheap stocks perform better than relatively expensive stocks over long periods of time
  • Calculated by taking the annual average return of cheap stocks (30% of stocks with the highest ratio of their book value divided by the value of their shares outstanding), and subtracting the annual average return of expensive stocks (30% of stocks with the lowest ratio of book value divided by the value of their shares outstanding)
  • This is also known as the Book to Market ratio, the most commonly used book value metric, but there are many 
  • From 1928 through 2019, the annual US Value premium has been 3.18% per year (DFA)

Persistent:

  • not as persistent as market beta, but more persistent than the size premium
  • In the US
    1. 63% - 1 year periods
    2. 72% - 3 year periods
    3. 78% - 5 year periods
    4. 86% - 10 year periods
    5. 94% - 20 year periods
  • In 2020 value has gone through its worst 3 year period of underperformance relative to growth (expensive stocks) in history
  • Recent value under-performance has caused people to wonder whether value “doesn’t work” anymore
  • But, as we just said, you can go through 5, 10, and even 20 year periods where it doesn’t work, and despite that it still has delivered higher relative returns than growth 
  • Patience is required (more on this in portfolio construction)

Pervasive:

  • Yes, value has been persistent across markets
  • Through the year ending in 2019, the value premium has been:
    1. 2.62% per year in Canada (1977-2019)
    2. 4.66% per year in International Developed Markets (1975-2019)
    3. 5.10% per year in Emerging Markets (1989-2019) (11.35%/yr vs. 6.25%/yr – HUGE)
      • $1000 invested in growth in 1989, worth $6,164.08 end of 2019
      • $1000 invested in value in 1989, worth $25,159.77 end of 2019 (OVER 4X)

Robust:

  • While most common value metric is Book to Market, there are other metrics that can be used to separate cheap from expensive stocks
  • If BTM was the only metric, we couldn’t say it’s robust, it could be the result of data mining
  • Value premium showed up in the US while measuring BTM as well as Cash flow to price, Earnings to Price

Investible:

  • Yes, Vanguard, DFA, AQR, Avantis – many low-cost fund families that pursue and have captured the value premium in a systematic way.

Sensible/Intuitive:

  • Risk Based Definitions
    1. Cheaper stocks contain a “distress” (risk factor)
    2. In a 1998 paper “Risk and Return of Value Stocks” written by Nai-fu Chen and Feng Zhang, they researched 3 intuitive measures of distress present in value companies:  cutting dividends by 25%, a high ratio of debt to equity, and high variability of earnings
    3. All 3 measures had high correlations to higher future returns, future returns were greater where these conditions were in existence
    4. In a 2005 study titled “The Value Premium”, Lu Zhang concluded that the value premium could be explained by the extra risks of value stocks
    5. This “asymmetric risk” exists because value stocks are usually companies with unproductive capital (plants, equipment, infrastructure), so during bad times the unproductive capital acts as a weight.   In good economic times, the unproductive capacity comes roaring back while growth companies struggle to increase capacity.   
    6. Value companies also tend to be more leveraged, making them riskier in bad times
    7. Finally, in a study “The Value Premium and Economic Activity: by Angela Black, Bin Mao, and David McMillan found that in times of economic expansion, when industrial production rises, value stocks become less risky relative to growth stocks
    8. They studied the period between 1959 and 2005 
    9. Also found that value premium is positively related to the money supply, and that value premium is stronger when interest rates are rising
    10. Also, stocks are more volatile than the market.   1927-2015 annual standard deviation of the Fama French Large Cap Index was 19.7%.  The STDV of the FF Large Cap Value Index (ex-utilities) was much higher (26.8%) – no free lunch!
    11. Same pattern with small stocks 
  • Behavioural Definitions
    1. investors are too optimistic in their expectations for the performance of growth companies and too pessimistic in their expectations of value companies
    2. ultimately prices correct when expectations are not met
    3. Investors confuse familiarity with safety (glamour or growth names)
    4. Anchoring – people tend to hang onto losing investments until they break even (ie. buying super expensive stocks and expecting them to bounce back quickly)
    5. Loss Aversion – people are more sensitive to losses than to gains, growth stocks tend to be companies that have performed well lately, so people are less concerned about future losses.  Value stocks, on the other hand, are associated with companies that have performed poorly in the recent past as evidenced by their low prices – less desirable.
    6. Final Note:  “Lottery Ticket Stocks” are alluring to investors – small chance for huge payoff.  Small cap growth stocks tend to be overpriced and can earn negative excess returns.   Poor returns of these stocks are reflected in the value premium

Profitability Premium

  • A recent breakthrough, the profitability premium is the discovery that firms with high profitability pleasured by earnings have high subsequent returns.
  • Sometimes is conflated with the quality premium
  • The main research on this factor was done by Robert Novy-Marx in his 2013 paper “The other side of value: The Gross Profitability Premium”.
  • Profitability, measured by the ratio of gross profits to assets, has roughly the same power as book-to-market in predicting the cross-section of average returns
  • Profitable firms generated significantly higher returns than unprofitable firms, despite having significantly higher valuation ratios.
  • Profitable firms tend to be growth firms, or “good growth” stocks – with high gross margins – it’s a factor that performs better when growth performs well
  • When you layer a profitability screen on top of value strategies, it tends to perform well and becomes a good hedge for value strategies – lowering overall volatility.
    1. Ie. in the US, Value underperformed growth in the 10 years between 2010 and 2019 by 3.95%/yr
    2. Profitability outperformed less profitable over the same period by 4.16% per year 
  • A great diversifying and smoothing factor 

Persistent:

  • US – 1964– 2019, the most profitable firms earned average returns 3.57%/yr greater than least profitable firms as a group

Pervasive:

  • Through the year ending in 2019, the profitability premium has been:
    1. 6.18% per year in Canada (1991-2019)
    2. 3.63% per year in International Developed Markets (1991-2019)
    3. 3.07% per year in Emerging Markets (1992-2019) 
Robust:
  • Robert Novy-Marx’s study investigated a variety of profitability measures and generally found good results
  • Research by AQR Capital Management found that three different measures of profitability all provide a premium:  toral profits to assets, free cash flow to assets, total profits to sales

Investible:

  • AQR and Dimensional incorporate profitability into the construction of funds as an “overlay” or screen
  • Low-turnover strategy, growth strategies, excellent hedge and volatility dampener for value strategies

Sensible:

Risk Based

    1. Trickier because more profitable firms are less prone to distress, suggesting they are less risky
    2. More profitable firms tend to be growth firms, which have more of their cash flows in the distant future, making them more-risky in the short term
    3. 2016 paper “The Excess Returns of “Quality” Stocks:  A Behavioural Anomaly” by Jean Philippe Bouchaud, Ciliberti Stefano, Augustin Landier, Guillaume Simon, and David Thesmar.
    4. They described a risk based explanation: firms choosing more risky projects only if they are potentially more profitable
  • Behaviour Based
    1. Analysts are overly optimistic
    2. The greater the profitability of the firm, the less optimistic they become, meaning that analysts as a group are more likely to under-value profitable companies 
    3. Helpful Sensibility story
      • 2 companies – Company A and Company B
      • Same products, Same plants, same equipment, same # of employees, same customers, same everything
      • The only difference – Company B is 25% more profitable than company A
      • Their stock prices are the same
      • Why?
      • Company B is clearly a more profitable, shouldn’t its price be higher?
      • It’s possible that there’s something else about that stock or company that is making it more risky “recent negative news, an org change that investors don’t like, some type of regulatory change”
      • Company B faces more risk, but the presence of the profitability advantage gives it a higher expected return and a higher premium

WRAP UP

  • So far we’ve covered Beta, Size, Value, and Profitability or “the big 4” for equities
  • Next week fixed income (bonds)
  • Questions to retirempod@gmail.com
  • Thanks for listening!

Reference:  Your Complete Guide to Factor-Based Investing: The Way Smart Money Invests Today: Berkin, Andrew L, Swedroe, Larry E: 9780692783658: Books - Amazon.ca