I apologize for the sensational headline, but it really captures my feelings on this topic. Who says the sell side does nothing? There is a new fantastic report out from Joao Toniato, Ph.D. of Barclays Capital titled EQUITY VALUATION ACADEMY: Value for money. The report is a fantastic study on value investing, specifically focusing on the following points;
1. SECTION 1: THE ‘WHY’ AND ‘HOW’ OF VALUE INVESTING A Three key lessons on value investing B Why does value outperform? C Is value riskier than growth? D Is this the moment for value?
2. SCREENING FOR VALUE A Three key lessons on value screens B How to capture value? C Not for the faint hearted – value needs a longer horizon D It’s a (value) trap! But you can avoid it
3. INVESTMENT CONCLUSIONS A Cash is king screen (non-financials) B Financials Value screen.
Since this report is so fantastic we have replicated it in its entirety (bar legal disclaimers below). The report is from 22 May 2013. Enjoy! Dont get scared by some of the academic stuff in the beginning.
SECTION 1: THE ‘WHY’ AND ‘HOW’ OF VALUE INVESTING
Three key lessons on value investing : Academic research has investigated the relationship between company valuation and stock market returns in great detail. The debate surrounding value stretches from the findings of Fama & French (1992)2, namely, that the price to book ratio explains a large portion of future stock returns, to recent papers such as Angelini et al. (2012)3, who conclude that the cyclically adjusted P/E is a powerful predictor of future index returns.
In this note we focus on the analysis of ‘value’ versus ‘growth’ stocks. The first group of stocks can be broadly defined as “bargains”, or stocks that trade at a low price relative to their fundamentals (ie, a stock with a low P/E ratio, low P/Book ratio, etc). Value investors often believe that the market has mispriced these companies and a correction will move prices up and generate returns. On the other hand, investing in growth stocks implies paying a premium price (ie, a high P/E, high P/Book, etc) for a stock that offers large growth potential. Investors who follow this route generally believe that the future growth will lead to stock outperformance.
We have examined the academic literature and added our own tests to identify the likelihood and causes of value outperformance and the best approaches to value screening.
We highlight three main lessons from our analysis:
- Value outperforms in the long run. This has been shown in a variety of academic studies4 and our own tests in Section 2 support this conclusion. The main reason is the different rerating of value and growth stocks. For most value stocks the valuation ratios grow after they are identified as value stocks. For the average growth name the opposite is true, as these companies tend to de-rate after they are identified as growth stocks. Value stocks experienced a positive P/E rerating in all but one of the past 13 years. On the other hand, growth names rerated negatively in 12 of the past 13 years. In relative terms the rerating of value stocks was higher than that of growth stocks in all years.
- Value and growth react very differently to earnings news due to the different growth expectations of each class of stock. Value stocks, on average, still show positive returns even after missing earnings forecasts. On the other hand growth names are punished by the market for missing consensus forecasts and only get rewarded when the company beats consensus by a large margin.
- Value is not necessarily riskier than growth. The volatility of value stocks is more often than not lower than that of growth names. In addition, the volatility of negative movements in price is higher in growth stocks in all of the past 13 years.
In addition to the above, we would highlight our view that the current environment is promising for value stocks. With central bank reflation efforts driving investors up the risk curve, easing policy uncertainty and a stretched premium for defensive growth. We believe we could be approaching a tipping point for value stocks.
Why does value investing outperform?
As far as heated debates in the halls of investing academia go, this is a serious contender for top spot. The general academic consensus is that value outperforms over the long run. However, one question remains: is the outperformance of value driven by a simple risk/reward story? (ie, investors take more risk when investing in value and to compensate for this risk are rewarded with larger average returns). Or are the returns of value and
growth investment strategies a consequence of mispricing? (i.e. the market often overreacts when value names fall out of favour and excessive hype is built around growth names).
Our view is that the latter is more likely the answer. But whether the reader concurs with us does not change the conclusion that value investing has delivered higher returns in the long run.
Re-rating drives the returns of value stocks
Diving deeper into the performance of value stocks, we start by breaking down returns on a single stock into its components:6 Returns can be divided into Dividend Yield and Capital appreciation. And the capital appreciation, by its turn, can be divided into earnings growth and earnings rerating.
We can see that by:
In Figures 5, 6 and 7 we look at each of these components individually. Value stocks, almost by definition, are expected to have higher dividend yields and in Figure 5 we show that the dividend component of returns alone has consistently been higher for value names.
The second component of returns yields more surprising results. Growth names, again almost by definition, are expected to have higher earnings growth. And in general that is what we found: in 11 of the past 13 years growth stocks had higher EPS growth than value names (Figure 6). However, the expectation of growth is the main reason for the premium investors pay for these stocks. And looking at the 12m ahead earnings growth over the past years, the results only partially support that the premium paid for growth was “money well spent”. We can see that the EPS growth advantage that investors received for growth stocks is not as consistent or high in magnitude as the dividend yield advantage value investors received for their investments.
While investing in value stocks implies paying for the dividend yield and investing in growth stocks implies paying for strong future earnings, should not come as a surprise, what is often ignored is the P/E rerating component.
The P/E rerating works as a multiplier which defines how much the earnings growth affects the capital appreciation/depreciation of the investment. So, for example, let us suppose that an investors buys £1000 of a stock and holds it for one year; and when the position is opened the stock has EPS = £10 and trades at a P/E = 10x. Now let us assume this stock doubles its EPS over the year. In this case the invested capital will only double if P/E stays put at 10x. But if the stock’s P/E rerates to 15x the capital will actually treble (i.e. when the position is closed: EPS £20 * P/E 15x = £3000) while, if the P/E de-rates to 5x the capital appreciation will be zero (i.e. when the position is closed: EPS £20 * P/E 5x = £1000).
With that in mind, we looked at the rerating of value and growth stocks over the same 13 year period. In Figure 7 we see that the rerating has magnified the returns of value names in all of these years except for 2008. While the returns on growth stocks were diluted by derating in all but one of the past 13 years.
Hence, while growth stocks benefit from stronger EPS, growth stocks tend to rerate negatively. In other words, as their earnings grow, the value the market attaches to these earnings is constantly falling. It appears that growth companies consume their growth opportunities quickly causing PEs to fall, so limiting the returns on investing in growth names.
The reverse is true of value names, which show (often strong) positive rerating in most years. Hence, even in the face of the weaker earnings growth shown by these stocks, the rerating adds to the higher yield and generally translates into outperformance of value stocks.
This type of analysis was suggested in The Anatomy of Value and Growth Stock Returns (by Fama & French)7. In this paper the authors conclude that value portfolios generate large capital gain returns via rerating. By contrast, growth stocks re-rate negatively causing the P/E ratios of growth and value portfolios to converge over time.
The analysis above begs a follow-up question:
How do value and growth stocks react to earnings news?
Given that value stocks appear to carry the expectation of low earnings growth, what happens to those value stocks where there is upside surprises on earnings? And if the price of growth stocks already implies high earnings expectations, are they still rewarded for reporting high earnings? To answer those questions, we look at the returns of value and growth stocks when they miss/beat analyst expectations.
In Figure 8 we plot the average 12m post earnings announcement returns of value and growth stocks since 2000. We can see that these two types of stocks react in very different ways depending on what was disclosed in the earnings announcement. It appears that the price investors pay for growth stocks on average already carries strong earnings expectations; so much so that unless the company beats consensus by a significant margin, the share price reaction is negative.
We note a few other interesting conclusions from the above chart: firstly, value stocks appear not to be punished by the market for missing analyst forecasts. These stocks seem to already carry the expectation of poor earnings in their valuation. Secondly, for value names even a small beat to consensus is largely rewarded by the market. Even more startling are the conclusions for growth stocks. Firstly, for growth stocks, missing analyst forecasts results in average negative returns. Secondly, the average growth name is not rewarded for a small beat to analyst forecasts, only strong surprises (>10% above forecast) result in positive returns.
Supporting the argument that the different reaction to earnings news drives much of the difference between the returns of value and growth stocks academic research (Good News for Value Stocks: Further Evidence of Market Efficiency – by La Porta, Lakonishok, Shleifer & Vishny8) has found that “the earnings announcement returns are substantially higher for value stocks than for glamour (growth) stocks”. In other words, as it is clear from Figure 8, positive reaction to earnings announcements are consistently more common for value names than for growth names.
This can also be seen by looking at a particular class of stock: value names that report earnings growth. Those value stocks that manage to grow earnings on a given year tend to yield very strong market performance as well. If we look at value stocks that grew earnings in the year after being selected as a value name (Figure 9) the returns are exceptionally strong.
In other words, the “holy grail” of value/growth investing appears to be investing in value names that will grow earnings/beat earnings expectations during that period. The question then becomes: how do we identify those value stocks with potential to surprise on earnings? These are truly the companies where the market has underestimated the potential of the assets in place, i.e. they are currently mispriced. We try to answer this question in Section 2 where we attempt to identify the best ways to screen for value and to avoid value traps.
Is value riskier than growth?
Now we turn back to the initial question of whether the outperformance of value is driven by risk or mispricing. As we wrote above, our view is that mispricing may play a larger part. First, the results we saw in Figure 8 above point in the direction of the mispricing theory. It appears that market earnings expectations about growth stocks are so high that even when earnings are marginally above analyst forecasts this does not translate into positive returns.
To further explore this we look at the volatility of value and growth stocks. These tests also imply that risk is not the determinant of value returns since in 8 of the past 12 years growth stocks showed higher volatility than value stocks (Figure 10).
The academic research answer to this question is still unclear and there is no consensus in the literature concerning this topic. On one side of the debate, a classic paper, Size and Book to Market Factors in Earnings and Returns (by Fama & French)9, argues that in the same way that value stocks yield higher price returns they also display higher risk. So these authors defend that the greater returns to value stocks are the result of this risk/reward trade-off.
The results from the tests of Fama and French indicate that the beta of the CAPM model alone is not capable of explaining the variation in returns across companies and that valuation and size play an important part in explaining returns. Fama and French frame their arguments along the lines of the Fama and French (FF) 3 factor model which is an expansion of the CAPM model10.
CAPM model: Rs – Rf = ? + ?*(Rm – Rf)
FF 3 Factor model: Rs – Rf = ? + ?*(Rm – Rf) + H*HML + S*SMB
Where: Rs is the return on a portfolio, Rm is the market return, Rf is the return on the risk free rate, HML is the ‘high minus low’ book to price factor (which is measured based on the historic outperformance of low P/B over high P/B stocks) and SML is the ‘small minus large’ size/liquidity factor (which is measured based on the historic outperformance of small cap over large cap stocks). So, while the CAPM argues that beta and the excess return on the market alone are able to explain single stock returns; the FF 3 factor model states that valuation (as captured by the price to book ratio) and stock liquidity/size also impact returns. Fama and French try to categorise the P/B and size factors along the same lines as beta; i.e. as factors that capture risk. However, their research fails to provide a sound economic rationale for why low P/B names would intrinsically carry greater risk.
This led other researchers (as well as Fama and French themselves) to question the risk explanation for the outperformance of value companies. In the paper, Contrarian Investment, Extrapolation, and Risk (by Lakonishok, Shleifer & Vishny) 11 argue that market participants “consistently overestimate future growth rates of growth stocks relative to value stocks” and that “value strategies appear to be no riskier than growth strategies”.
This implies that the returns to value stocks are a consequence of mispricing.
Another important point is that the 4 years when value showed higher volatility were also years in which value stocks significantly outperformed growth stocks. This suggests that the volatility we are looking at even in those 4 years is a “good volatility”, i.e. prices increasing fast rather than falling.
We investigate this “good volatility” theory further by looking at the downside deviation (i.e. the standard deviation of